Wednesday, July 27, 2011

SEC Press Release: Structured Products

SEC Staff Issues Summary Report of Sweep Examination of Structured Products Sold to Retail Investors

The Securities and Exchange Commission (SEC) issued a press release today announcing that it had
issued a report identifying common weaknesses seen in sales of structured securities products and describing measures by broker-dealers to better protect retail investors from fraud and abusive sales practices.
The report is a result of studies in the structured products business of 11 broker-dealers. The report found that broker-dealers might have made unsuitable recommendations of structured products to customers, sold products at prices that hurt customers, “engaged in questionable sales practices”, and “omitted material facts” about structured products from customers. Moreover, the Staff (that wrote the report) suspects that broker-dealers failed to provide adequate supervision of, and training for, their brokers who marketed and sold structured products. The report can be found here.

Almost six years ago, we saw the Financial Industry Regulatory Authority (FINRA) publish guidance notes to members concerning their obligations in relation to the sale of structured products. Four such obligations are worth noting. First, members are required to “perform a reasonable-basis suitability determination.” Second, members must “deal fairly with customers with regard to derivative products.” Third, firms must “supervise and maintain a supervisory control system.” Fourth, firms must “train associated persons” (p.1).

Evidently, six years have passed and more than a few brokers have failed to meet such obligations. For example, it was only six days ago that the state of Georgia subpoenaed UBS AG, Morgan Stanley and Ameriprise Financial Inc. requesting information from these brokerage firms in an investigation into whether these firms violated state securities’ laws in the sale of reverse convertibles, a structured product.

From the report we can see that the structured products market is in need of more adequate supervision. Investors can better protect themselves by looking more closely at the hidden risks and costs of structured products. Investors should fully understand, amongst other things, a structured product’s payoff structures, all associated fees, liquidity and credit risks, and risks associated with the reference asset before committing to purchasing it.

SLCG has a dedicated website providing papers, notes and calculation tools on a variety of structured products which may be of help to investors. Related papers include:

Tuesday, July 26, 2011

SEC Press Release: New Short Form Criteria

SEC Adopts New Short Form Criteria to Replace Credit Ratings

The Securities and Exchange Commission (SEC) issued a press release today announcing that it had removed “credit ratings as eligibility criteria for companies seeking to use ‘short form’ registration when registering securities for public sale.” The SEC unanimously voted for the adoption of this new rule, in response to the Dodd-Frank Wall Street Reform and Consumer Protection Act that encouraged financial regulators to rely less on credit ratings.

How should an investor interpret credit ratings? Check out what Standard and Poor’s says on its website:
Ratings should not be viewed as assurances of credit quality or exact measures of the likelihood of default. Rather, ratings denote a relative level of credit risk that reflects a rating agency’s carefully considered and analytically informed opinion as to the creditworthiness of an issuer or the credit quality of a particular debt issue. (Credit Ratings Are Expressions of Opinion About Credit Risk)
Two expressions to note are “[ratings] should not be viewed as assurances … or exact measures” and “ratings denote a relative level of credit risk.”

Firstly, while the ratings are not exact measurements of likelihood of default, they are qualitative expressions of likelihood of default. According to Standard and Poor’s, a security with an AAA rating means that the issuer of the security has an “extremely strong capacity to meet financial commitments” while a security with a BBB rating means that the issuer of the security has an “adequate capacity to meet financial commitments” (Credit Ratings Definitions & FAQs). Secondly, not only are ratings qualitative expressions of likelihood of default, they are relative expressions. A security with a rating of AAA means that its issuer is considered more creditworthy than the issuer of a security with a credit rating of, say, BBB, or that the credit quality of the former issue is considered higher than the credit quality of the latter issue.

While credit ratings of individual securities are assigned by private rating agencies, bond mutual funds report an ‘average credit quality’ statistic which is not assigned by private rating agencies, but is calculated by the funds as a weighted average of the credit ratings of the individual securities held by the funds.

What do the average credit quality statistics, given by mutual funds that are trying to sell themselves, tell us about the true credit quality of the mutual funds? If you are interested in our findings, read our paper on the topic of mutual fund average credit quality. Investors are invited to visit our dedicated website for more papers and up-to-date news.

Monday, July 25, 2011

FINRA Investor Alert: Asking the Right Questions

The Grass Isn’t Always Greener—Chasing Return in a Challenging Investment Environment

The Financial Industry Regulatory Authority (FINRA) published an Investor Alert to help retail investors, who are seeking for higher returns through investing in complex securities such as structured products, ask the right questions before making such investment decisions.

Investors are encouraged to read through the FINRA article. The article includes a section on ‘Structured Retail Products’, since we have conducted significant research on this topic.

There are different types of structured retail products. Once such product is the principal protected note. The principal protected note does not pay interest. Its payoff is linked to the an underlying security or index, but it returns at minimum the face value of the note at maturity if the underlying security or index falls below an amount that equates to the face value of the note. There is a risk that the note returns less than a comparable fixed income security, or that the note returns nothing at all. There is liquidity risk, the risk that an investor who wants to sell her principal protected note before maturity might not be able to due to the lack of a secondary market. There is credit risk, the risk that the issuer fails to pay investors any or all of the returns to the note. There are other risks.

Over the past few months, structured products have continued to receive the attention of regulatory authorities. Back in April this year, FINRA fined UBS Financial Services $10.75 million for failing to emphasize that the Lehman-issued 100% principal protected notes sold to investors “were unsecured obligations of Lehman Brothers.” Back in June this year, the Securities and Exchange Commission (SEC) warned about investing specifically in principal protected notes.

We at SLCG believe that regulatory authorities provide valuable information for retail investors. SLCG has a dedicated website providing papers, notes and calculation tools on a variety of structured products. Specifically, we have written related papers on:

Thursday, July 21, 2011

In the News: UBS & Morgan Stanley Subpoenaed over Reverse Convertibles

UBS, Morgan Stanley Subpoenaed Over Reverse Convertibles

Bloomberg news reported today that the state of Georgia had sent subpoenas requesting for data and other information from UBS AG, Morgan Stanley and Ameriprise Financial Inc.. The state is investigating whether these brokerage firms violated the securities laws of Georgia in their sale of reverse convertibles to investors of Georgia.

Sales of reverse convertibles have grown, and investors who are being sold these structured products include the elderly and those with little money. The brokers are required recommend products suitable to their clients, must not omit material facts about the products, and firms are required to establish and maintain adequate supervision and training of their brokers. These are just some of the obligations recommended under Financial Industry Regulatory Authority’s (FINRA) guidance notes on the sale of structured products.

Suitability is hugely important when the product is complex but the target investors – such as the elderly and those with little net-wealth – are unsophisticated.

What, then, is a reverse convertible?

A reverse convertible note is a type of structured product that is linked to an equity security or an index. It is a short-term note that pays a relatively high coupon rate compared to traditional notes. The returns of the note at maturity depends on whether the equity, called ‘reference asset’, falls below a pre-specified trigger price during the term of the note. If it does, then the note returns the market value of the number of shares of the reference asset which could have been purchased on the note’s pricing date with the note’s face value. If it does not, then the note returns its face value.

SLCG has written a paper on the topic including a paper that values and analyzes a large sample of reverse convertible notes. We find that these notes are largely and consistently overpriced, yet reverse convertibles continue to be sold which, combined with the complexity of and the lack of a secondary market for these notes, implies that investors do not fully understand the returns and risks of these notes.

In short, a reverse convertible is a complex product and unsophisticated investors must make every effort to understand the hidden costs, risks and terms and conditions of such a product before being persuaded by brokers to purchase a structured product such as the reverse convertible.

Wednesday, July 20, 2011

Dishonest Sales of LEFTs by RBC Capital Markets

Secretary Galvin Charges RBC Capital Markets and Agent with Dishonest Sales of Leveraged and Inverse Leveraged Exchange Traded Funds 

The Enforcement Section of the Massachusetts Securities Division of the Office of the Secretary of the Commonwealth alleges that Michael Zukowski, a registered representative of RBC Capital Markets, made “numerous unsuitable recommendations and sales” of leveraged and inverse leveraged exchange traded funds (ETFs) to clients who did not understand the risks of such ETFs. Through approximately 629 transactions, Zukowki’s 35 clients lost over $790,000 in their investments in leveraged and inverse ETFs. 

Furthermore, the Enforcement Section alleges that RBC Capital Markets did not provide any training for registered representatives on such ETFs at the time these were recommended and sold. RBC Capital Markets, therefore, failed to provide adequate supervision of Zukowski which led him to make such unsuitable recommendations. For more information, see the Complaint and Exhibits

Leveraged ETFs leverage an index and inverse ETFs are investments that return the inverse of the return of an index. Both ETFs experienced huge growth in the past few years, from $200 million in assets under management in mid-2006 to $32 billion in mid-2010. One key risk is that, for those who hold leveraged and inverse ETFs for longer than one or two days, long-term returns of the ETFs adversely deviate from the long-term returns of the ETFs’ benchmark index due to the daily rebalancing of portfolios. The Enforcement Section alleges that this key risk was not properly understood by, or communicated to, Zukowki’s clients.

SLCG has written a paper on leveraged and inverse leverage ETFs. In the paper, we show that many investors hold ETFs for period longer than one or two days and estimate how much such investors can lose when investing in leveraged and index ETFs.

Friday, July 15, 2011

SEC Press Release: State of Municipal Securities Market

SEC Announces July 29 Field Hearing on the State of the Municipal Securities Market

The Securities and Exchange Commission (SEC) issued a press release today announcing that 
it will hold a municipal securities market field hearing in Jefferson County, Ala., on July 29. Topics will include distressed communities, small issuers, disclosure, derivatives and pre-trade price transparency.
The purpose of the field hearing is to understand the relevant issues affecting investors in the municipal securities market which may lead to changes in rules, legislation, or best practices guidelines. The SEC has general oversight of the municipal securities market with the purpose of improving multiple aspects of the market, such as financial reporting, accounting, transparency, disclosure and general investor protection and education.

SEC’s efforts are timely, given that over the past six months there have been cases of fraud in the municipal securities market involving brokerage firms. For example, back in January of this year, the SEC charged two former portfolio managers of a Utah municipal bond fund for collecting over $500,000 in ‘credit monitoring fees’ to municipal issuers when such fees went straight to the two people.

SLCG has a dedicated website containing papers and research, include those that relate to municipal bonds:

SEC Press Release: Forex Ponzi Scheme

SEC Charges Forex Ponzi Operator Who Fled After Scheme Unraveled

The U.S. Securities and Exchange Commission (SEC) issued a press release today announcing that it had
filed fraud charges Thursday against the CEO of a purported foreign currency trading firm, alleging he scammed hundreds of investors with false promises of high, fixed-rate returns while secretly using their money to fund his start-up alternative newspaper.
Lowrance, Chief Executive of First Capital Savings & Loan Ltd., raised money across 26 states in the U.S. from investors by guaranteeing them huge profits through a foreign currency trading program. The money was then used to fund Lowrance’s newspaper, pay Lowrance and pay off other investors in a Ponzi scheme. Here are the SEC Complaint and the Litigation Release No. 22040.

Thursday, July 7, 2011

SEC Press Release: Fraudulent Bidding Practices

SEC Charges J. P. Morgan Securities with Fraudulent Bidding Practices Involving Investment of Municipal Bond Proceeds

The U.S. Securities and Exchange Commission (SEC) issued a press release today announcing that it has
charged J.P. Morgan Securities LLC (JPMS) with fraudulently rigging at least 93 municipal bond reinvestment transactions in 31 states, generating millions of dollars in ill-gotten gains.
Here are the SEC Complaint, SEC Final Judgment and the Litigation Release No. 22031.

Charges against brokerage firms for rigging the competitive bidding process of reinvestment products have continued over the past 8 months. This is at least the third instance in which a brokerage firm has been charged for rigging. Previous charges were made against Banc of America Securities and UBS who with their affiliates were charged over $136 million and $160 million respectively.

Profitable, fraudulent activity in the market is contagious when it works and when there is a lack of regulation and oversight.

Municipal bonds are bonds issued by government entities at the city, county and state levels. Municipalities issue bonds to finance their projects for the public good. These bonds are called municipal bonds, and their rates may be fixed or floating. They are usually long term bonds. Municipalities usually use the proceeds of the bonds to purchase reinvestment products before using them for the municipalities’ intended purpose.

SLCG has written several papers relating to municipal bonds:
Investors may find in our dedicated website many other interesting papers and notes.