A type of high risk investment product that imploded with the economic meltdown in the Fall of 2008, leading to investors' losses of hundreds of millions of dollars, continues to concern securities regulators. The Securities and Exchange Commission (SEC) has joined with the Financial Industry Regulatory Authority (FINRA) to issue a joint Investor Alert to warn investors about complex financial products known as "structured notes with principal protection." While the name of this security suggests safety, the structured notes present a variety of extreme risks to uninformed investors.
The notes combine a zero-coupon bond, which pays no interest until the bond matures, with an option or other derivative product whose payoff is linked to an underlying index, benchmark or other asset. These notes are designed to return some of all of an investor's money at a set maturity date (which can be as long as ten years) and offer a potential interest payment linked to a predetermined change in the value of the underlying asset.
There are many risky variations of both components that make up the structured note product. For example, although some notes return the entire amount of an investor's principal at maturity, many return less than 100 percent. Moreover, the principal guarantee -- that investors will receive all or some of their principal at maturity -- is entirely dependent on the creditworthiness of the securities firm that structures and issues the note. If the issuer goes bankrupt -- as was the case with Lehman Brothers, which issued large volumes of these type of notes -- investors have no protection and become unsecured creditors of the defunct firm.
The potential upside benefit of being able to participate in an increase in the underlying assets is similarly subject to signficant risks depending upon how the note is structured. As a result, the issuer can limit the amount of interest it owes investors even if the note reaches maturity. The upside potential is linked to the performance of the underlying assets, which are not limited to common benchmarks such as the S&P 500 or the price of a single commodity. Rather, exotic cominbations of assets such as spreads between interest rates or baskets combining unrelated asset types such as an index, a commodity and a currency, are often chosen as the meaure of interest the bond will ultimately pay above the return of principal. The issuer can select unfavorable formulas to calculate the gains or losses linked the the performance of the underlying asset, so-called "market-linked" returns, which can limit the extent to which investors are allowed to participate in the underlying asset's gains. Additionally, the issuer can determine that only a portion of the underlying asset's gain is credited to the note, which has the effect of restricting the interest paid to the investor at maturity.
The unlimited variations to the structure of these complex financial products makes it difficult for typical investors to assess the true risks and benefits of the notes. For this reason, the SEC and FINRA issued their Investor Alert and provided a series of questions that investors should ask their advisers who recommend structured notes with principal protection, such as: (a) what is the level of principal protection offered, (b) describe any conditions to the principal protection, (c) what are the fees and costs, (d) are there limits to potential gains in the underlying asset, (e) what is the credit risk of the issuer, (f) what other risks are associated with the product, and (g) what alternative investments are available.
Complex risks often hide behind the safe-sounding structured notes, and investors should be wary of recommendations to invest without obtaining direct and clear explanations. Any investor who has lost significant monies in these type of structured notes should consider consulting with an investment fraud lawyer to determine any liability on the part of the financial advisor recommending the security.
