Sec & Finra Issues Joint Warning About Principal Protected Notes

The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have issued a joint warning to retail investors about investing in complex financial products and specifically that structured notes with principal protection are not risk free, according to Bloomberg. These popular investment vehicles combine a zero coupon bond, one that pays no interest until it matures, with an option whose payoff is linked with an underlying asset, index or benchmark. The performance of the linked index will determine the payoff but the bonds offer the possibility of a better return than money market instruments, increasing their popularity. The warning comes on the heels of an increasing number of retail investors investing in the products, seeking potentially higher returns in a low interest rate environment, according to FINRA.

The belief by investors that these products provide upside potential while protecting their principal is not necessarily true. Often the principal is not protected, while some do guarantee 100% principal protection and that is good unless the issuer of the note goes bankrupt, in which investors can lose their principal as with Lehman Brothers 100% Principal Protected Notes. UBS Financial Services paid $10.75 million in fines and restitution to settle FINRA claims that it had misled customers about the “principal protection” feature of the Lehman Brothers Holdings notes.

The SEC is concerned that the principal protection feature often protects a small portion of the principal, such as 10%, and then only if a contingency set forth in the prospectus is met. Even the upside potential is complicated and difficult to determine, since the investor’s gains are determined by the extent the linked index rises. If the index rises 40%, the investor would receive the full 40% gain but, if the index rises more than 40%, the gain would be considerably less. Finally, in order to receive the full payout, investors must hold these notes to maturity, which could be as long as 10 years perhaps causing an additional tax burden due to the imputed gains.

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