Structured products—also referred to as structured notes or structured credit—are complex, hybrid products that combine a bond with a derivative component. “Derivatives” get their value from an asset, like a stock or a futures contract.
As described by the SEC, structured notes can be linked to individual equities or an equity index, foreign currencies, interest rates, and other assets or indexes.
Firms may advertise structured notes as products that come with upside potential and principal protection, but the reality is that these products often offer more risk than reward.
How Structured Notes Work: Maturity Dates and Returns
Structured notes are typically designed and issued by large financial institutions and sold to retail investors by broker-dealers. It’s important to be aware that structured products do not represent ownership of any portfolio of assets.
Instead, the structured product represents a promise to pay made by the issuer—this is the bond component. At the set maturity date, the investor receives some or all of the principal paid. Some structured products may feature some form of principal protection, but this is uncommon.
Additionally, the investor receives a return based on a change in the underlying asset’s value. For example, a commodity-linked structured product will pay higher returns when its chosen market index increases in value.
If you hold your structured note until maturity, you will receive at least a portion of your initial investment. Depending on the performance of the underlying asset or portfolio, you may also receive additional returns, but these are not promised.
However, even your principal may not be guaranteed if the issuer struggles to make payments. If your issuer falls into bankruptcy, you could lose the entirety of your initial investment.
What Makes Structured Products Complex
The financial institutions that design structured products can structure their notes any way they want, and the seemingly endless possibilities can overwhelm even the most sophisticated investor.
Structured notes are typically offered to institutional and accredited investors – i.e., companies and particularly wealthy investors. They are often unsuitable for ordinary retail investors.
If your broker recommended structured investment products, resulting in investment portfolio losses, you should contact a securities attorney right away. Our team at Kurta Law is ready to assist with your case.
Risks Associated with Structured Notes
Structured products come with a variety of different risks that investors should know about. If your broker fails to disclose these risks when making the investment recommendation, you can hold them liable for any investment losses you suffer.
Complexity
Many investors find it difficult to understand the ins and outs of structured products. In fact, the obscure features of some structured products make them difficult to fully comprehend even for investment professionals.
Many structured notes determine their returns through a calculation involving the participation rate. The participation rate of a structured note is an increase in the underlying asset multiplied by a percentage defined by the issuer. For example, if a structured product had a participation rate of 60% and was linked to an equity index that increased in value by 10%, then you would receive 6% returns.
On the other hand, some structured products cap the returns you can receive. Even if the underlying assets perform well, you won’t receive more than the maximum return.
All these complicated features also make it difficult to determine what taxes you’ll pay on your structured note. A tax advisor can help you evaluate the potential consequences of a structured product before you purchase.
Uncertainty
Because the payoffs for structured products depend on the performance of their linked assets, these returns are never guaranteed, creating a fundamental risk for investors.
Most structured notes utilize a complex payoff structure, making it difficult for investors to assess the value, risk, and potential for growth through the term of the structured note. It’s important to carefully read the prospectus for your structured product to understand how the payoff will be calculated.
Some structured products may have features that contribute to this uncertainty:
- Knock-in/knock-out options: Also called a barrier or trigger, the knock-in is a predetermined level of value that will alter your note’s payoff structure if your note passes the level. Depending on your structured note, this may trigger the derivative component of your note (knock-in) or it may end that component entirely (knock-out).
- Calls: If your structured product has a call provision, the issuer can redeem the note before its maturity date at any price, regardless of its face value. This essentially ends the investment with a final payout, without any input from the investor.
These features can result in sudden loss of principal, making structured products especially risky for investors.
Liquidity
Structured notes present serious liquidity issues for investors, as there is no secondary market for the products.
The exception is exchange-traded notes (ETNs), a type of structured product linked to a market index, e.g., stocks. However, most structured products are not ETNs.
Typically, an investor seeking to sell a structured note has two potential buyers: the broker-dealer affiliate of the issuing financial institution, or the broker-dealer who distributed the note.
The issuer will typically disclaim their intention to repurchase or make markets in the notes they issue. Thus, you should hold a structured product to its maturity date if possible. Otherwise, you’ll risk selling the product at a loss.
In limited circumstances, an issuer may allow you to redeem your note before maturity. However, they will likely require payment of a penalty for redeeming the note prior to its maturity date.
Creditworthiness of the Issuer
Structured products represent the unsecured debt obligations of the issuing financial institution. That means the issuer has an obligation to make payments on the note once it reaches maturity.
However, just because the issuer makes these promises does not necessarily mean they will follow through. If the issuer of your structured note files for bankruptcy, there is a good chance you will lose some or all of your investment.
For example, many investors who owned structured products issued by Lehman Brothers incurred heavy investment losses when Lehman Brothers filed for bankruptcy in September 2008.
Common Types of Structured Notes
Below are some of the types of structured notes most commonly seen in cases of investment fraud.
Market-Linked Notes
Many structured products are market-linked, meaning they tie their returns to the performance of a certain market, such as foreign currencies, commodities, or exchange-traded funds. Though they may promise especially high yields and seem simple enough, these are still complex investments.
Principal-Protected Notes (PPN)
Most structured notes do not offer principal protection. PPNs market themselves as notes that protect the initial investment in case the underlying asset declines in value.
But the fine print on any PPN will tell you: the principal protection is subject to the creditworthiness of the issuer. If the issuer goes bankrupt, the investor will lose their entire principal.
PPNs do not pay a coupon but pay interest accrued upon maturity. They do not offer investors any payments until they reach maturity.
Reverse Convertible Notes
Reverse convertible notes, also called “yield enhanced bonds,” combine a bond and a put option. A put options contract gives the purchaser the right to sell a particular share at a set price.
Because this is a “reverse” note, this means the issuer can repurchase it from you if the underlying asset (often a stock or stock index) falls below the knock-in price. In exchange, you’ll receive the underlying shares—converting your debt into equity.
The bond component of a reverse convertible note pays a fixed coupon. Reverse convertible notes rely on their linked assets remaining steady in price, as investors won’t profit from an increase and may lose the note if it declines.
Reverse convertible notes are short-term investments that typically mature in three months to a year.
Auto-Callable Yield Notes
Auto-callable yield notes offer a higher interest rate than other bonds. These notes can be called – i.e., redeemed – at set observation dates if the price of the underlying share reaches a predetermined price, known as the “call hurdle.”
If the underlying asset closes at or above a different predetermined price on periodic observation dates, the note will not be called and will instead continue with its usual payments until the next date.
Auto-Callable Contingent Income Barrier Notes
Auto-callable contingent income barrier notes may be redeemed by the issuer if interest rates rise. At this point, the investor receives their principal amount plus any interest.
The “contingent income barrier” refers to the threshold at which the note will be automatically called by the issuer. If the underlying assets drop below a certain price, the note will be called and the investor will lose part of their principal.
Leveraged Structured Notes
Also called “enhanced participation notes,” leveraged structured notes use borrowed money to enhance the opportunity for especially high returns. As any broker should warn their customers, this increased chance of a bigger yield comes with the amplified opportunity for a total loss.
Variable Interest Rate Structured Products
Variable interest rate structured products (VRSPs) offer investors fixed-interest rate payments for their first few years, but switch to variable-interest rate payments after that period ends.
However, these payments depend on the long-term Constant Maturity Swap (CMS) rate of U.S. Treasury bonds being higher than the short-term CMS rate. Payments are also linked to the performance of reference indexes.
Accordingly, investors can see their payments dry up once the fixed-interest period ends and may lose their entire principal.
Broker Obligations Concerning Structured Products
The complexity and confusion surrounding structured products have influenced regulatory agencies to issue notices concerning the obligations of brokers recommending these investment products.
National Association of Securities Dealers: Notice to Members 05-59
In 2005, the National Association of Securities Dealers (NASD) issued guidance on the sales practice obligations for NASD members when selling structured products.
- First, the NASD emphasized the need for brokers to provide a “fair and balanced picture” of the risks and benefits of a structured product.
- Second, the NASD directed member firms to consider whether to limit purchases of structured products to investors whose accounts have been approved for options trading.
- Third, the NASD reminded members of their obligation to perform a reasonable basis suitability analysis and a customer-specific suitability analysis.
- Fourth, the NASD mandated that members establish written supervisory procedures reasonably designed to ensure compliance with applicable securities laws and regulations regarding the sale of structured products.
- Finally, the NASD required member firms to train registered personnel about the characteristics, risks, and rewards associated with each structured product before allowing them to sell the products to investors.
Reasonable-Basis Suitability
A reasonable-basis suitability analysis requires the broker to have a reasonable basis to believe, based on due diligence they conducted, that the investment or investment strategy recommended is suitable for at least some investors. The advisor’s research should provide them with an understanding of the benefits and risks associated with the investment product.
Customer-Specific Suitability
A customer-specific suitability analysis requires the broker to have a reasonable basis to believe the recommendation is suitable for a specific customer’s investment profile. Whether an investment is suitable for a customer’s investment profile depends on several factors, including their:
- Age;
- Financial situation and needs;
- Tax status;
- Investment objectives;
- Investment time horizon;
- Liquidity needs;
- Investment experience; and
- Risk tolerance.
Advisors must take these considerations into account when deciding whether to recommend such an investment to a client.
Financial Industry Regulatory Authority: Regulatory Notice 12-03
In March 2012, FINRA issued a regulatory notice regarding the characteristics, risks, and benefits associated with structured products. The notice further addressed the use of heightened procedures that can help FINRA member firms ensure investors know the features of the investment they are purchasing.
FINRA suggests firms implement formal written procedures to prevent registered representatives from recommending a structured product before it has been thoroughly vetted. The procedures should ensure brokers know the answers to extensive questions about the product, such as:
- Who is considered an ideal investor for this type of product?
- Is this product unsuitable for certain investors? If so, who?
- What is the product’s investment objective?
- What risks does a structured product present to my investment portfolio?
- How will the firm and registered representative receive compensation for offering this product?
- How does the complexity of this product affect suitability considerations or training requirements associated with the product?
- Can I sell the structured product easily?
If a registered representative can satisfactorily answer questions about the product’s characteristics, the procedures have served their purpose.
FINRA emphasized the importance of the mandates initiated by the NASD, including having an internal procedure to review the suitability of structured products and giving registered representatives adequate training to understand the features and risks associated with structured products.
In the News: Structured Notes Settlements
Brokerage firms are regularly subject to allegations of unsuitable investment recommendations and misrepresentations of material facts related to their investments. Below are some recent examples of allegations involving structured products.
Stifel Nicolaus & Company
In 2023, investors were awarded nearly $2 million in compensatory damages and another $9 million in punitive damages by Stifel Nicolaus & Company after making allegations involving structured notes, fraud, and violation of the Florida Securities and Investor Protection Act.
The following year, investors received approximately $2.35 million in damages in another dispute against the firm, alleging fraud and violations of both the Florida Securities and Investor Protection Act and the Employee Retirement Income Security Act (ERISA).
Centaurus Financial
Centaurus Financial settled charges made by the SEC in 2023 which alleged unsuitable recommendations of variable interest rate structured products (VRSPs) to retail investors. This settlement included a civil penalty of $750,000.
Aegis Capital Corporation
In 2022, the SEC alleged that Aegis Capital Corporation’s managing director, Alan Appelbaum, made unsuitable recommendations of VRSPs to seven investors. These structured products were allegedly unsuitable given the clients “moderate” risk tolerance, liquidity needs, and investment objectives.
The SEC further alleged that 14 additional Aegis Capital brokers also recommended unsuitable VRSPs to 48 investors. Aegis Capital settled with the SEC, consenting to a civil penalty of $2.3 million.
Morgan Stanley
Kurta Law is investigating broker recommendations of Morgan Stanley structured investments. Brokers such as Lawrence Catena and Joshua Westerman have faced allegations of unsuitable recommendations of structured products while associated with Morgan Stanley.
Did You Lose Money on Any of These Structured Products?
Kurta Law is also investigating the following structured products. Contact a securities attorney if you lost money on any of these complex investments. Call 877-600-0098 or email info@kurtalawfirm.com.
- HSBC Contingent Income Auto-Callable Securities, based on the worst performing of the Nikkei Stock Average, the Russell 2000 Index and the S&P 500 Index, due December 17, 2026
- Scotiabank Contingent Income Auto-Callable Securities, based on the performance of Common Stock of Moderna, due January 2, 2026
- Scotiabank Contingent Income Auto-Callable Securities, based on the performance of the common stock of Meta Platforms, due on or about January 20, 2028
- Bank of America Callable Contingent Income Securities, based on the S&P 500 Index, the Russell 2000 Index, and the NASDAQ-100 Index, due November 27, 2026
- Morgan Stanley Market Linked Securities (Leveraged Upside Participation and Contingent Downside), linked to the S&P 500 Index, due January 24, 2034
- Morgan Stanley Contingent Income Auto-Callable Securities, based on the worst performing of the Energy Select Sector SPDR Fund and the Utilities Select Sector SPDR fund, due March 23, 2027
- Morgan Stanley Market Linked Securities (Auto-Callable with Contingent Coupon with Memory Feature and Contingent Downside), based on lowest performing of the common stock of AbbVie Inc., common stock of CVS Health Corporation, and common stock of Pfizer Inc., due September 11, 2026
- Morgan Stanley Trigger Jump Securities, based on the value of the common stock of NVIDIA Corporation, due April 6, 2026
- Barclays Moderna Structured Product, Due November 8, 2024
- Barclays Barrier Dual Directional Notes, linked to Plug Power Inc., Global Medium-Term Notes, Series A, due September 23, 2024
- BNP Paribas Contingent Income Notes linked to the worst of the NASDAQ-100 Index, the Russell 2000 Index, and the S&P 500 Index
- Bank of America Contingent Income Auto-Callable Yield Notes linked to the common stock of Peloton Interactive
- GS Financial Corp. Contingent Income Auto-Callable Securities based on the performance of the common stock of Moderna, due November 29, 2024
- JP Morgan Structured Investments: Trigger Jump Securities based on the performance of the common stock of Moderna, due January 24, 2023
- Morgan Stanley Contingent Auto-Callable Securities, based on the performance of the Common Stock of Moderna, due May 22, 2024
- Credit Suisse New York Reverse Convertible, linked to the performance of the common stock of Beyond, Inc, due March 6, 2019
- Crédit Agricole Corp, linked to the performance of L Brands (Now BBWI), Nutanix, and Twitter, due April 24, 2020
- Citigroup Global Markets linked to Affirm, Fubo, and Twitter, due September 29, 2022
- Credit Suisse AG linked to Dycom Industries, Roku, and Teva, due August 30, 2019
- Credit Suisse AG London, Reverse Convertible Note linked to IQIYI Inc. Due July 17, 2019
- Société Générale Reverse Convertible Note linked to Lemonade Insurance. Due February 10, 2022
- Credit Suisse London Reverse Convertible linked to CrowdStrike, Lemonade, Snow. Due December 16, 2021
- Société Générale Reverse Convertible linked to Universal Display Corporation and Weibo Corp. Due January 28, 2019