Wednesday, September 28, 2016

This is why UBS paid the SEC $15 Million over Reverse Convertible Structured Products By Craig McCann, PhD, CFA and Mike Yan, PhD, CFA, FRM The Securities and Exchange Commission today announced a$15 million settlement with UBS over structured products linked to high volatility stocks today. The SEC press release announcing the settlement is available here and its Order Instituting Proceedings is available here. This post explains the underlying notes and why UBS may have paid the SEC a substantial settlement over sales practices related to UBS’s reverse convertible notes (“RCNs”).

UBS sold thousands of structured notes to retail investors in recent years. Some of those notes, the RCNs, pay a higher coupon than traditional notes but expose investors to the downside risk in single stocks. When an investor buys a reverse convertible note they are selling a put option on the underlying asset and paying the purchase price of the note to fully collateralize the investor’s obligation to pay the issuer if the short put option is in the money at maturity. The RCN coupon is partly interest on the collateral the investor posts and partly compensation for the short put option which exposes investors to the underlying asset’s downside risk.

UBS has a significant information advantage over retail investors and therefore the risk investors take on when purchasing an RCN from UBS might be significantly higher than they expect and the high coupon they receive not high enough to compensate them for the downside risk. We have published several peer-reviewed papers on the structured notes and posted on www.SLCG.com over twenty thousand research report on the retail structured products.

We searched 424B2 filings on SEC’s EDGAR for RCNs linked to a single stock issued in 2011 and 2012 and found that UBS Financial Services was the Placement Agent for 1,152 RCNs listed in Table 1, which means UBS Financial Services purchased those RCNs from the issuer in the offering and sold the notes to its clients. The issuers of those RCNs include Barclays, Deutsche Bank, HSBC, JP Morgan, Morgan Stanley, Royal Bank of Canada, and UBS.

Table 1: Reverse Convertible Notes Sold by UBS Financial Services in 2011 and 2012

A. RCN Description

A single observation reverse convertible note (“SO RCN”) can be valued as a combination of a note from the issuer, a short European out-of-the-money cash-or-nothing binary put option, and a short European out-of-the-money put option on the underlying stock.

Figure 1: The Final Payoff of the SO RCNs.
For example, UBS trigger yield optimization notes linked to the common stock of Halliburton Company issued in January 2011 is a single observation reverse convertible.1 The 1-year notes pay monthly coupon at an annualized rate of 10.53%. At maturity, the notes pay the market value of one share of Halliburton Company’s common stock if the stock price falls below 80% of the initial level at the final observation date. In this case, the investors suffer a loss of more than 20%. Otherwise, the notes pay back the principal.

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The Halliburton-linked structured product payoff is the same as receiving the $39.23 face value of the note less$7.85 if the stock closes below $31.38 on the valuation date (this is the payoff to 7.85 short cash-or-nothing put options with a strike price of$31.38), less the amount if any Halliburton closes below $31.38 (this is the payoff to a short put option with a strike price of$31.38).

An airbag single observation reverse convertible note (“Airbag RCN”) can be valued as a combination of a note from the issuer, and some short European out-of-the-money put options on the underlying stock. The number of the options equals the ratio of the current underlying price and the strike price of the put option. For example, if the strike price is 80% of the initial index level, then the ratio 1.25 is the share number of the put option.

Figure 2: The final payoff of the airbag single observation reverse convertible
UBS airbag trigger yield optimization notes linked to Apple Inc. issued in April 2012 is an example of the airbag single observation reverse convertible. The 6-month notes pay monthly coupon at an annualized rate of 7.91%. The maturity payoff of the principal is reduced by the product of 1/0.85 and the losses of the Apple stock beyond the 15% buffer. Otherwise, the notes pay back the full principal.

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2http://www.sec.gov/Archives/edgar/data/1114446/000119312512179022/d338724d424b2.htm.

An autocallable reverse convertible note (“Autocallable RCN”) can have maturity payoffs which look like either Figure 1 or Figure 2, paying the face value if the underlying doesn’t close below a trigger price. In addition, autocallable RCNs have a call feature allowing the issuer to refund the entire principal early at pre-determined call dates, if the underlying price exceeds the initial level on the call date. Once the notes pre-pays its principal, no further coupons or principal payments will be made.

B. Selection of Stocks with High Implied Volatility

Once the structure of a reverse convertible – single observation, airbag, autocallable – and the term, trigger and coupon are specified the note’s fair market value depends on the volatility of the underlying stock. The more volatile the stock, the more likely the stock price is to be below the trigger resulting in losses to the investor. Holding constant the other attributes of the RCN, UBS could benefit at the expense of its retail clients by selecting higher volatility stocks.

In fact, we find that UBS selects underlying stocks for its RCNs with unusually high volatilities. 73% of the stocks underlying UBS’s RCNs were in the S&P 500. 16% are from the additional 2,500 stocks in the Russell 3000 but not in the S&P 500. The remaining underlying stocks appear to be mostly stocks issued by large foreign issuers that would be in the S&P 500 if they were US stocks.

Of the underlying stocks chosen by UBS that were in the S&P 500, 83.7% were in the top half of the distribution of implied volatilities within the S&P 500 when the RCNs were issued. This number increases to 95.6% when we include the underlying that are outside of the S&P 500. This is extremely strong evidence that UBS was selecting unusually volatile stocks from the pool of stocks and that this harmed investors.

Figure 3 is a histogram of the market value of UBS’s RCNs issued in 2011 and 2012 sorted by the distribution of volatilities in the S&P 500 at the time UBS issued the notes. If UBS was not purposely selecting underlying stocks with high volatilities, the histogram would be flat with each vertical bar representing 10% of the market capitalization of the RCNs issued. Instead the distribution is skewed sharply towards the higher volatilities found in S&P 500 stocks.

Figure 3: Most of UBS’s RCNs Linked to S&P 500 Stocks, Mostly More Volatile

C. What the Implied Volatility Tells You

The information of the implied volatility is useful for investors. When the investors purchased RCNs, what matters is the uncertainty surrounding the future value of the underlying stock. The best estimate of this uncertainty is likely to be the volatility implied by option prices although it could be the consensus volatility forecasts of dealers (they should be the same). In any case, that there is some variation in dealers’ forecasts is irrelevant to determining the best estimate of future volatility.

Although the implied volatilities historically overestimate realized volatility, this difference between implied volatilities and realized volatility seems to be related to the non-normality of returns and compensation for volatility risk. Both are equally of concern to purchasers of reverse convertibles as they are to direct sellers of options. Thus, that implied volatilities overestimate realized volatility doesn’t make them inappropriate for valuing reverse convertibles or assessing the risk of losses upon conversion to stock payoffs.

Knowing the term, underlying stock and threshold of the reverse convertible is insufficient for an investor to develop an opinion of the likelihood that the reverse convertible will convert into the underlying stock. For instance - and directly on point – investors might believe that the underlying stock is about as volatile as the S&P 500 or the Dow Jones Industrial Average levels commonly reported each day. Because this belief would be mistaken, it would cause investors to underestimate the likelihood of the note converting into stock at maturity and overestimate the value of the reverse convertible note.

The only way for investors to develop a good estimate of this likelihood on the issue date is for the investor to know the implied volatility of the stock. The implied volatilities of the S&P 500 stocks which underlie 73% of UBS’s reverse convertible issuances were nearly double the contemporaneous S&P 500 implied volatility; reverse convertible investors who intuit the risk of converting to stock by thinking about the volatility of the S&P 500 will be significantly mistaken.

Tuesday, September 13, 2016

Craig McCann’s Comment Letter in Support of NASAA’s REIT Guidelines

Yesterday, Craig McCann, President of SLCG, submitted a comment letter in support of NASAA’s proposed concentration limit for nontraded REITs. He also urged NASAA to find a mechanism for ensuring roll-up and advisory contract protections promised by Sponsors to investors as a condition for receiving registration permission are not summarily eliminated when capital raises end and investors truly need these protections. Dr. McCann’s comment letter is available here.

Wednesday, September 7, 2016

More on the Sordid Tale of the Global Net Lease and ARC Global Trust II Merger

By Craig McCann and Regina Meng

On August 11, 2016 we wrote about the recently announced merger of Global Net Lease, Inc. (GNL) and American Realty Capital Global Trust II (ARC Global Trust II). See Sacha Baron Cohen and Nicholas Schorsch – Masters of the House! ARC Global Trust II's 8-K announcing the merger and merger agreement can be downloaded here.

Global Net Lease had been non-traded REIT ARC Global Trust Inc. but began trading on the NYSE under the ticker GNL on June 2, 2015. Our full June 5, 2015 blog post on ARC Global Trust / GNL can be downloaded here.

In total, Thenardier and the brokerage firms selling just these two of his American Realty Capital products have cost investors $684 million -$587 million as a result of ARC Global Trust / GNL and \$97 million as a result of ARC Global Trust II.

NASAA’s Vanishing Roll-up Protection

Non-traded REITs are required by state securities regulators to include language that closely tracks the 2007 North American Securities Administrators Association’s Statement of Policy Regarding Real Estate Investment Trusts (available here) in their bylaws. NASAA guidelines protect shareholders in REITs which have not been trading for at least 12 months before being rolled-up.

Non-traded REIT shareholders need protection because, unlike traded REIT shareholders, they can’t observe thickly traded market transaction prices when assessing the value of their shares. Also, non-traded REIT shareholders can’t rely on the market for corporate control to bid up the merger consideration if risk arbitrageurs determine the value offered is too low. This need is especially pronounced when, as is often the case in suspect acquisitions skirting the roll-up protections, the acquiring traded REIT is affiliated with the acquired non-traded REIT through the Sponsor.

The protections afforded by the NASAA guidelines include the requirement or a contemporaneous independent appraisal of the non-traded REIT and the option for the non-traded REIT investors who vote against a proposed roll-up to receive their pro rata share of the appraised value.

Last year we wrote about how ARC and Cole Capital used a form for correcting typos to remove the roll-up protections it granted investors. See Nicholas Schorsch Cheated Investors in Recent Nontraded REIT Mergers. Despite promising NASAA and investors to provide shareholder protections, these two sponsors eliminated them so the Sponsors could push through abusive mergers.

ARC Global Trust II Abandon’s Shareholder Protection From Abuse by ARC in a Rollup

On April 29, 2016, just 4 months before the merger announcement, ARC Global Trust II tried to delete the roll-up provision altogether because it said the provision was ambiguous and might define a transaction in which its securities had not been listed for 12 months as a roll-up and thus implicate dissenter appraisal rights. The board of directors of Global II proposed to remove the provision completely from the company’s bylaw, saying that the roll-up provisions “may limit the ability to engage in a transaction involving our securities if our securities have not been listed on a national securities exchange for at least 12 months among other substantive transactional requirements.”

--See ARC Global Trust II’s Notice of Annual Meeting of Stockholders at page 40.
Of course, there is no ambiguity in NASAA’s roll-up protection requirement. Global Trust II had used Thenardier’s post January 2012 sleight-of-hand roll-up protection language to avoid providing roll-up protection to investor. Still Global Trust II thought it might still be required to act in its shareholders’ interests and so tried to remove any doubt by deleting the provision altogether.

The proposal, along with other proposals, is later withdrawn by the company after a meeting of a special committee comprised entirely of independent directors. See ARC Global Trust II’s Supplemental Proxy Information.

At page 22 of the Merger Agreement, ARC Global Trust II tells its objecting shareholders they have no rights.

Of course, ARC Global Trust II knows this perfidy should prompt remedial action and so it slipped into its bylaws with the merger announcement a forum selection amendment requiring any derivative action be brought in Maryland courts.

See August 5, 2016 Amendment No. 1 to Bylaws

Of course, Thenardiers don’t have a conscience and can’t be shamed into treating other people fairly or even legally. Someone should be looking into this. In the meantime, we’ll be back shortly with some information on Mr. Schorsch’s independent directors who approved this mess.

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