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Category Archives: Structured Products

SEC Charges Merrill Lynch With Misleading Investors in CDOs

The brokerage firm of Merrill Lynch will pay $131.8 million to settle charges it misled investors about two collateralized debt obligations (CDOs)  it structured and marketed, as well as maintaining inaccurate books and records for a third CDO. The Securities and Exchange Commission (SEC) announced the settlement on Thursday.

The SEC’s order found that Merrill Lynch failed to inform investors that the hedge fund firm Magnetar Capital LLC had a third-party role and exercised significant influence over the selection of collateral for the CDOs titled Octans I CDO Ltd. and Norma CDO I Ltd.  According to the SEC, Magnetar bought the equity in the CDOs and its interests were not necessarily aligned with those of other investors because it hedged its equity positions by shorting against the products.

“Merrill Lynch marketed complex CDO investments using misleading materials that portrayed an independent process for collateral selection that was in the best interests of long-term debt investors,” said George S. Canellos, co-director of the SEC’s Division of Enforcement, in a statement. “Investors did not have the benefit of knowing that a prominent hedge fund firm with its own interests was heavily involved behind the scenes in selecting the underlying portfolios.”

Merrill Lynch agreed to the settlement without admitting or denying the SEC’s findings.

All of the actions in question took place before Merrill Lynch was acquired by the Bank of America in 2009. Specifically, according to the SEC’s order, Merrill Lynch engaged in the misconduct in 2006 and 2007 when its CDO group was a leading arranger of structured product CDOs.  After four Merrill Lynch representatives met with a Magnetar representative in May 2006, an internal email explained the arrangement as “we pick mutually agreeable [collateral] managers to work with, Magnetar plays a significant role in the structure and composition of the portfolio … and in return [Magnetar] retain[s] the equity class and we distribute the debt.”

The email further noted that the Merrill Lynch reps agreed in principle to conduct a series of deals with largely synthetic collateral and a short list of collateral managers.  The equity piece of a CDO transaction is typically the hardest to sell and the greatest impediment to closing a CDO.  Magnetar’s willingness to buy the equity in a series of CDOs therefore gave the firm substantial leverage to influence portfolio composition.

You can read the SEC’s entire decision here.


Mass. Securities Regulators Looking Into Alternative Products Sold to Seniors

Sales involving alternative investment products sold to elderly investors has an unleashed an investigation by Massachusetts securities regulators into 15 brokerage firms. The firms include LPL Financial LLC, Morgan Stanley, Merrill Lynch, UBS Securities LLC, Fidelity Brokerage Services LLC, Charles Schwab & Co. Inc., Wells Fargo Advisors, TD Ameritrade Inc., ING Financial Partners Inc.,  Commonwealth Financial Network, MML Investor Services LLC, Investors Capital Corp., Signator Investors Inc., Meyers Associates LP, and WFG Investments Inc.

As reported yesterday, the Massachusetts securities division has sent subpoenas to the firms being targeted, asking for information on sales of the products to state residents who are 65 or over.  Among the non-traditional investments included on the list:  Oil and gas partnerships, private placements, structured products, hedge funds and tenant-in-common offerings.

Massachusetts is demanding information on any such products that have been sold over the past year, the investors who purchased them, the commissions generated, how the sales were reviewed, and all relevant compliance, training and marketing materials used for marketing and sales purposes.

The firms have until July 24 to respond.

This isn’t the first time that Massachusetts has come down hard on broker/dealers for alleged improper sales of certain alternative investments. In May, the state settled cases involving non-traded REITs with Ameriprise Financial Services; Commonwealth Financial Network; Lincoln Financial Advisors Corp., Royal Alliance Associates; and Securities America. The five firms agreed to pay a total of $6.1 million in restitution to investors, as well as fines totaling $975,000.

In February, Massachusetts reached a similar settlement with LPL Financial, which agreed to pay at least $2 million in restitution and $500,000 in fines related to sales of non-traded REIT investments.

The REIT investigations “heightened my concern that the senior marketplace is being targeted for the sales of these high-risk, esoteric products,” said Massachusetts Secretary of the Commonwealth William F. Galvin in a statement yesterday.

“While these products are not unsuitable in and of themselves, they are accidents waiting to happen when they are sold to inexperienced investors by untrained agents who push the products to score … large commissions.”

More Investors Burned by Structured Products

Structured investments have rendered a countless number of investors financially ruined – many of whom would never have been invested in the exotic products if not for the recommendations of their financial advisor.  The 2008 financial crisis cast a new light on the potential problems of structured products, from so-called principal-protected investments issued by Lehman Brothers to reverse convertible notes from Morgan Stanley. The result was the same: Investors lost big.

Jargon-laden literature, illiquidity, counter-party risk and lack of transparency all make structured products a complex and often unsuitable investment for the average investor. Despite these characterizations, many financial advisors continue to sell structured products because of the large mark-ups and commissions they bring – not because they are in the best interests of a client.

In the case of Morgan Stanley, a review by the Financial Industry Regulatory Authority (FINRA) into sales of the firm’s structured products – which included principal-protected investments, leveraged exposure, yield enhancement, and access investments – revealed that in many instances the true risks of the structured products were never disclosed to clients.

FINRA’s findings were officially documented in a Letter of Acceptance, Waiver and Consent (AWC) in which Morgan Stanley signed on Dec. 7, 2011, and agreed to pay a $600,000 fine to settle the violations outlined. Among the violations cited: Supervisory deficiencies, as well as unsuitable recommendations of structured products to retail customers.

In the AWC letter, FINRA states that Morgan Stanley failed to create “reasonable systems or procedures to notify supervisors whether structured product purchases complied with the firm’s internal guidelines.” Instead, Morgan Stanley placed the responsibility with branch supervisors.

“During the Review Period, Morgan Stanley had no reports or tools for sales supervisors or compliance personnel that were specific to structured products, or which highlighted and detected single concentrated structured product purchases. As a result, of the 224,000 structured product purchases between September 2006 and August 2008, more than 28,000 were in net amounts that exceeded 25% of the customer’s disclosed liquid net worth and more than 2,600 were effected by customers with slated net worth less than $100,000,” the AWC letter said.



Complex Investment Products in Hot Water With FINRA

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.

Morgan Stanley Pinnacle Notes Lawsuit to Move Forward

A federal judge has decided that Morgan Stanley must face the music and defend itself in a lawsuit brought by 18 Singapore investors over failed structured products. Among the allegations, investors accuse Morgan Stanley of committing fraud in 2006 and 2007 when it sold them nearly $155 million of Pinnacle Notes structured products. The notes, which were linked to synthetic collateralized debt obligations (CDOs), lost almost 100% of their value amid the financial crisis.

Morgan Stanley tried to get the lawsuit dismissed, but District Judge Leonard Sand rejected its request.

“Defendants point to generalized warnings cautioning investors not to rely solely on the offering materials,” Judge Sand stated in this ruling. “But even a sophisticated investor armed with a bevy of accountants, financial advisors and lawyers could not have known that Morgan Stanley would select inherently risky underlying assets and short them.”

As reported Nov. 4 by Reuters, the October 2010 lawsuit is seeking class-action status. It is one of several lawsuits accusing banks of misleading investors into buying supposedly safe securities backed by risky debt, even as other investors or the banks themselves were actually shorting them.

In the Morgan Stanley case – Dandong et al. vs. Pinnacle Performance Ltd et al., U.S. District Court, Southern District of New York, No. 10-08086 – plaintiffs allege that the bank represented the Pinnacle Notes as “conservative” and that they would keep their principal safe.

Instead, Morgan Stanley allegedly invested their money into synthetic CDOs that were tied to risky companies. In addition, investors say they were kept in the dark to the fact that Morgan Stanley acted as a counterparty in the CDO deal whereby it collected one dollar for every dollar investors lost.

“Morgan Stanley designed the synthetic CDOs to fail,” the complaint said. “It placed itself on the side guaranteed to win (the “short” side) and placed plaintiffs and the class on the side guaranteed to lose (the “long” side).”

A Primer on Structured Investment Products

Arbitration claims involving structured investments have become a growing source of contention among investors – many of whom have experienced massive financial losses because of these Wall Street-engineered instruments.

Structured investment products, or SIPs, take several forms. Typically, they entail securities mixed with other derivatives, with a repayment value that is linked to the performance of the underlying assets. The assets can include a single security, a pool of securities, stock, bonds, debt issuances, foreign currencies or swaps.

For years, structured investments have been touted by brokers as a way for risk-wary investors to take advantage of stocks or other investments without having to actually “own” those investments. At the same time, investors could maintain a level of protection in the event of any losses.

What many of these brokers failed to add is that the “protection” in principal-protected notes is contingent on the solvency of the company linked to the note.

Lehman Brothers Holdings is a prime example. When Lehman filed for bankruptcy in September 2008, investors holding Lehman Return Optimization Securities and 100% Principal Protected Notes became stuck with essentially worthless investments. Today, these products are trading for pennies on the dollar.

Many investors who bought structured products are retirees. They sought the investments on the recommendation of their brokers, who touted the “conservative,” “minimal risk,” and “principal-protected” benefits of the products. Those benefits, however, never materialized.

At minimum, investors believed that principal-protected notes like those of Lehman Brothers would allow them to always maintain their principal original investment. Lehman’s own marketing brochures even advertised the products this way.

Lawsuits and arbitration filings over structured investment products have risen significantly in past few years. Among the allegations in the complaints: Investors were never informed about the potential risks of structured investments. Moreover, they never realized that the “investment product” they had put their money and faith behind was actually the unsecured debt of the issuer. If that company went bankrupt, as in the case of Lehman, their investment disappeared, as well.

UBS AG Yield Optimization Notes: What You Need to Know

Maddox, Hargett & Caruso currently is investigating complaints tied to UBS structured investments and the way in which the products were marketed and sold to investors.

Specifically, numerous complaints allege that these products, which include the UBS AG Yield Optimization Notes with Contingent Protection linked to the common stock of Lehman Brothers Holdings, were sold by certain brokers with the characterization that investors’ principal investment would be fully protected.

In reality, these notes subjected investors to significantly more risk than they expected based on the risk characterization portrayed by their broker. Many of the investors who eventually purchased UBS AG Yield Optimization Notes were conservative, risk-averse investors looking to preserve their capital and generate income.

UBS AG Yield Optimization Notes are considered a reverse convertible. This type of investment is not only difficult to understand but also highly risky. In the case of the UBS Optimization Notes, the investment’s actual performance was linked to Lehman Brothers stock. When Lehman Brothers filed bankruptcy in September 2008, the notes became worthless.

As a result, investors lost all their principal investment. The contingent protection associated with the product turned out to be of little benefit because that protection vanished overnight when Lehman’s stock price went south.

Many investors failed to realize key details about UBS AG Yield Optimization notes because certain information was never disclosed to them. Making matters worse: They also never learned about the worsening financial condition of Lehman Brothers – until it became too late.

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.

Structured Products: Who’s Buying, Who’s Saying ‘No’

The wealthiest U.S. investors are putting fewer dollars into structured financial products than the less affluent, according to a study by the Securities Industry and Financial Markets Association.

As reported Nov. 11 by Investment News, U.S. investors bought more than a $42 billion of structured notes this year. Nearly every major bank or brokerage sells structured products. Morgan Stanley leads the pack, issuing $10.1 billion, the most of any bank, followed by Bank of America Corp., which issued $7.9 billion.

Because of their complexity, structured products are not for those who don’t fully understand them. Moreover, once an investor puts money into a structured product, he or she is essentially locked in for the duration of the contract.

And, contrary to promises of principal by some brokers, investors can still lose money – and a lot of it – in structured notes.

Case in point: Lehman Brothers Holdings. Investors who invested in principal-protected notes issued by Lehman Brothers lost almost all of their investment when Lehman filed for bankruptcy in September 2008. In total, structured products have been linked to an estimated $1 billion in investor losses in just Lehman notes.

Investors have since filed arbitration claims against UBS, one of the largest sellers of Lehman structured notes.

Other structured investment vehicles like reverse convertibles and equity-linked notes also have become the target of arbitration claims, as well as investigations by state regulators.

Most structured notes are “a hot mess,” said Janet Tavakoli, president of Tavakoli Structured Finance in Chicago in an Oct. 20, 2010, article by the New York Times. “Most professionals can’t analyze them. When I have done it, I find these notes are loaded with hidden fees and hidden risks.”

If you have suffered investment losses in principal-protected structured notes and wish to discuss filing an individual arbitration claim with Financial Industry Regulatory Authority (FINRA), please contact us.

Northern Trust Involved In Pension Fund Lawsuit

Botched financial planning is the accusation facing Northern Trust Company, which has been sued by the Chicago Teachers’ Pension Fund over claims that the investment company breached its fiduciary duty and made unsuitable investments in risky, long-term securities that ultimately plummeted in value. 

The lawsuit – which seeks class-action status – was filed by Public School Teachers’ Pension and Retirement Fund of Chicago and the city of Atlanta Firefighters’ Pension Plan. It also names Northern Trust Investments N.A. 

As reported Feb. 2 by Pensions & Investments, the lawsuit stems from a Northern Trust securities lending program.  Specifically, the 43-page complaint states that instead of investing the Chicago and Atlanta funds in conservative, highly liquid, ultra short-term investment funds, “Northern Trust, in flagrant violation of its duties, locked the funds into risky, long-term investments – including hundreds of millions of dollars of unregistered, illiquid securities that plummeted in value.” 

On July 31, 2007, almost 70% of the securities held in the Short-Term Extendable Portfolio (STEP) were not due to mature for more than a year-and-a-half, and more than 20% of the securities in STEP were not due for at least 10 years,” the suit alleges. 

“The STEP portfolio included hundreds of millions of dollars in exotic, unregistered securities issued by structured investment vehicles, or SIVs – entities that were recently identified in hearings before the congressional Financial Crisis Inquiry Commission as one of the causes of the financial crisis that served no good or productive purpose in the financial system – and millions more in securities backed by risky residential mortgages and other consumer loans.” 

As of July 31, 2007, more than 15% of the securities in STEP were invested in unregistered securities – securities which, by definition, can only be sold under certain narrow circumstances and for which there is no ready market, the suit said. 

Those unregistered securities included two structured investment vehicles, Sigma Finance and Theta Finance Corp. Both were created and managed by the United Kingdom-based investment management company, Gordian Knot.  According to the lawsuit, the notes issued by SIVs are exotic, high-risk investments that were outside the enumerated classes of securities permitted to be held in STEP. 

The lawsuit further contends that because SIVs in general – and Sigma and Theta in particular – lacked an established track record, they were entirely inappropriate investments for a conservative fund such as STEP. 

The complaint also cites what could be some telling information by Northern Trust’s chief economist, Paul Kasriel. In 2006, according to the complaint, Kasriel said the following: “The U.S. housing market was in a ‘recession’ and that the housing market would ‘pull the economy down’ in 2007.” 

Northern Trust, however, ignored the warnings of its own chief economist and kept the collateral pools invested in securities, the lawsuit states. And those securities had significant exposure to mortgage-backed securities, SIVs and financial institutions that (Mr.) Kasriel warned were overly exposed to mortgage-backed investments. 

Northern Trust has denied the allegations.

Columbia Strategic Cash Portfolio Fund Spells Money Woes For Some Institutional Investors

The fate of the Columbia Strategic Cash Portfolio Fund was sealed on Dec. 10, 2007, when losses on investments in mortgage and certain asset-backed securities combined with a $20 billion withdrawal from a single institutional investor forced Bank of America to shutter one of the largest U.S. short-term funds catering to institutional investors.

The Columbia Strategic Cash Portfolio Fund is run by Columbia Management, a unit of Bank of America. Described as an enhanced cash fund and a suitable substitute for money market accounts, the Columbia Strategic Cash Portfolio Fund went from $40 billion in assets to about $12 billion in a matter of months.

The reasons behind the forced liquidation of the Columbia Strategic Cash Portfolio can be traced to its exposure to risky asset-backed securities and structured investment vehicles (SIVs) tied to real-estate mortgages. Some of the SIVs associated with the fund were later downgraded by credit-ratings agencies, creating more losses for the fund.

Unlike traditional money-market funds, the Strategic Cash fund didn’t provide investors with a guarantee to maintain a $1-per-share net asset value.

At the time the Columbia Strategic Cash Portfolio was shuttered, only a few investors found themselves able to liquidate their positions. Other investors were given a pro rata share of the fund’s underlying securities in lieu of cash. And still other shareholders were told they could cash out at the fund’s current share price at a loss.

The liquidity problems associated with enhanced cash funds like the Columbia Strategic Cash Portfolio are reminiscent of those found in auction rate securities, investments once deemed as a safe haven for individual and institutional investors to park their cash. When the market for auction rate securities collapsed in February 2008, however, investors quickly discovered that their investments were far from cash-like.

And that’s exactly what many investors in the Columbia Strategic Cash Portfolio Fund have discovered. Case in point: Costco Wholesale Corporation. As reported May 16, 2008, by the Puget Sound Business Journal, Costco unsuccessfully tried to pull out of several enhanced cash funds in 2008, with $371 million that remained frozen in the Columbia fund and two similar funds. In turn, Costco was forced to report a $2.8 million write-down on investments in those funds because of the decline in their value, according to the company’s 2008 10-K filing with the Securities and Exchange Commission (SEC).

Other companies affected by the Columbia fund include Getty Images. As of March 31, 2008, Getty had $20.4 million invested in the Columbia Strategic Cash Portfolio Fund. According to the Puget Sound story, Getty reported a $400,000 loss because of the decline in the value of the fund.

Another company, SonoSite, Inc., had $8.2 million tied up in the Columbia fund as of March 31. Ultimately, the medical devices company reported $300,000 in losses from that investment.

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