Variable Interest Rate Structured Products (“VRSPs”) are complex, structured securities, typically issued by large well-known financial institutions, that offer guaranteed periodic fixed-interest rate payments, typically for one to three years.
However, after the fixed-interest rate periods ends, VRSPs make periodic variable-interest rate payments, but only if a spread exists in which the long-term Constant Maturity Swap (“CMS”) rate is greater than the short-term CMS rate and certain reference securities indexes, such as the S&P 500 and/or the Russell 2000 stock indexes, do not decline by more than a specified percentage.
Accordingly, once the fixed-interest rate payment periods end, the Customers are not guaranteed to receive any further interest payments from the VRSPs. Most VRSPs also disclosed the risk of non-payment of interest, stating, for example, that, “there can be no assurance that [investors] will receive a contingent interest payment on any interest payment date” and that “the securities are not a suitable investment for investors who require regular fixed income payments, since the contingent interest payments are variable and may be zero.”
VRSPs are different from traditional bonds issued by financial institutions in several important ways. First, unlike traditional bonds, which provide periodic fixed-interest payments that are directly linked to a bond issuer’s ability to make periodic payments and which repay principal at maturity, the VRSPs offer variable interest payments based on formulas tied to differences in Constant Maturity Swap (“CMS”) rates for longer term and shorter term United States Treasury obligations, as well as to the performance of reference assets, such as certain equity indexes.
While the VRSPs initially pay fixed introductory or “teaser” rates for one to five years. After the introductory period, additional interest payments are not guaranteed and are contingent on the performance and interplay of the VRSPs derivative components such as the CMS rates and underlying reference indexes. These characteristics contribute to their unsuitability for the customers, who relied on periodic interest payments from their investments to meet their income needs.
Also, most VRSPs have maturity periods of fifteen years or more and typically lack active secondary markets, with no assurance of liquidity. These characteristics contribute to their unsuitability for the customers, who had investment time horizons of less than fifteen years and moderate or higher liquidity needs.
Also unlike traditional bonds, the VRSPs are “principal-at-risk” securities, which means that the customers can lose some or all of their invested principal at maturity if the VRSPs’ respective reference assets fail to perform within pre-determined ranges at maturity.
As several preliminary prospectuses for the VRSPs expressly warn: “There is no minimum payment at maturity. Accordingly, investors may lose up to their entire initial investment in the securities.” This characteristic contributes to their unsuitability for the customers, who were unwilling to risk losing their entire invested principal from their investments.
VRSPs are also “principal-at-risk” securities, which means that the Customers can lose some or all of their invested principal if the VRSPs’ respective reference securities indexes fail to perform within pre-determined ranges at maturity. For example, preliminary prospectuses for VRSPs sold to the Customers expressly warned that: “There is no minimum payment at maturity on the securities. Accordingly, investors may lose up to their entire initial investment in the securities.”
VRSPs also typically have maturity periods of fifteen years or more and are not certain to trade in a liquid secondary market, which means investors may not be able to sell them. The prospectuses, which typically the broker is expected to read to support their “reasonable basis” suitability obligations typically disclose that: “The securities will not be listed on any securities exchange. Therefore, there may be little or no secondary market for the securities. Even if there is a secondary market, it may not provide enough liquidity to allow you to trade or sell the securities easily. Accordingly, you should be willing to hold your securities to maturity.”
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