Friday, June 3, 2011

Principal Protection Notes: Timely Warning from the SEC?

For the past two years we have been investigating investor claims regarding principal protection notes and the litigation and arbitrations that have followed. Millions of dollars have been lost in these notes.

Today the SEC demonstrated one of the more significant issues with its regulatory program - closing the barn door after the horses are gone. Today, years after these sales of principal protection notes to thousands of investors, the SEC's  Office of Investor Education and Advocacy and the Financial Industry Regulatory Authority (FINRA) has issued an investor alert regarding the product. Years after the fact.

The alert, called Structured Notes with Principal Protection: Note the Terms of Your Investment is intended to educate investors about the risks of structured notes with principal protection, and to help them understand how these complex financial products work. While the SEC correctly notes that the retail market for these notes has grown in recent years, it completely overlooks the fact that thousands of investors have already lost hundreds of millions of dollars in these notes.

Structured notes with principal protection typically 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 asset, index or benchmark. The underlying asset, index or benchmark can vary widely, from commonly cited market benchmarks to currencies, commodities and spreads between interest rates. The investor is entitled to participate in a return that is linked to a specified change in the value of the underlying asset. However, investors should know that these notes might be structured in a way such that their upside exposure to the underlying asset, index or benchmark is limited or capped.

Investors who hold these notes until maturity will typically get back at least some of their investment, even if the underlying asset, index or benchmark declines. But protection levels vary, with some of these products guaranteeing as little as 10 percent — and any guarantee is only as good as the financial strength of the company that makes that promise.

“Structured notes with principal protection contain risks that may surprise many investors and can have payout structures that are difficult to understand,” said Lori J. Schock, Director of the SEC’s Office of Investor Education and Advocacy. “This alert is a ‘must read’ for investors considering these products, especially those with the mistaken belief that these investments offer complete downside protection.”

“The current low interest rate environment might make the potentially higher yields offered by structured notes with principal protection enticing to investors,” said FINRA Senior Vice President for Investor Education John Gannon. “But retail investors should realize that chasing a higher yield by investing in these products could mean winding up with an expensive, risky, complex and illiquid investment.”

Our firm has been advising investors and financial advisors who were mislead by the wirehouses regarding the safety of principal protection notes since 2008, and continues to do so. If you have any questions about such cases, feel free to contact us at


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