broker fraud

Broker-dealers have long offered a range of structured securities to institutions and wealthy individuals. Certain structured securities products have been increasingly marketed to retail investors in recent year. According to a recent report by the United States Securities & Exchange Commission, on Issues Identified in Examinations of Certain Structured Securities Products Sold to Retail Investors, structured securities products have resumed an overall upward sales trend in 2009 and 2010, and sales to retail investors have, on an estimated basis, risen from $34 billion in 2009 to $45 billion in 2010.

Structured Products

Structured products encompass a range of financial instruments, such as securities that derive their value from, and provide exposure to, various asset classes, including, among other things, a single security, baskets of securities, indices, options, commodities, debt issuances and/or foreign currencies. Structured securities products generally do not represent ownership of a particular asset (such as stock in a manufacturing company); instead, the products promise returns to investors based on the performance of one or more underlying assets.

Structured products intended for retail distribution, which are sometimes listed on an exchange, typically have some form of option or other embedded financial derivative exposure. They may be described as offering, among other things, partial or full “principal protection,” higher interest payments, or leveraged and/or asymmetrical exposure to the underlying asset class

Policy Issues Raised By Structured Products

According to a recent paper, “Policy Issues Raised By Structured Products,” Jennifer Bethel & Allen Ferrell, Discussion Paper No. 56010/2006 John M. Olin Center For Law, Economics And Business (Harvard), The structured products market has experienced explosive growth in the United States over thelast five years. The market is expected to continue growing 20%-25% each year, given the still comparatively small size of the U.S. market and the expected increase in demand for fixed income type investments by retiring baby-boomers. While often performing an invaluable role in facilitating the transfer of risk and improving the ability of investors to more fully diversify their portfolios, these products also raise important investor protection concerns. Investment banks are increasingly offering structured products to retail investors through their broker networks.

As the paper noted, Whether retail investors adequately understand the complicated payoff structure of these products, which often include embedded options, and the implicit fees being charged for these products is the source of these investor protection concerns. The illiquidity of most structured products, including even listed ones, heightens these concerns.

SEC Examinations of Certain Structured Securities Products

As the SEC Noted in its examinations of Certain Structured Securities Products Sold to Retail Investors, broker-dealers might have:

  • recommended unsuitable structured securities products to retail investors
  • traded at prices disadvantageous to retail investors
  • omitted material facts about structured securities products offered to retail investors
  • engaged in questionable sales practices with customers

The SEC also found that most of the retail firms did not have procedures in place consistent with this suggested guideline or take other appropriate steps prior to retail customers investment in these products, and that in connection with those unsuitable recommendations, it also appears that some of the firms failed to conduct any sort of supervisory review of the suitability of these recommendations.

Potential supervisory deficiencies were observed as well. In particular, there appears to have been a lack of training requirements for supervisors and registered representatives that market structured products to their customers. The report contains recommendations for improved surveillance of sales practices and enhanced training for sales and supervisory personnel.

“Sales of structured products to retail investors have increased over recent years and may continue to increase as they are marketed as a higher return investment alternative,” said the Director of the SEC’s Office of Compliance Inspections and Examinations. “This report could help companies strengthen their compliance programs to better address the issues we observed during our sweep and in subsequent exams.”

“Beyond this report, we are monitoring the way in which these products evolve, and are considering additional steps in the near future relating to structured securities products that may further bolster investor protection.”

The staff report states that larger broker-dealers should focus on issues such as:

  • having adequate procedures and controls to prevent and detect possible abuses in the secondary market for structured securities products
  • disclosing material facts regarding the structured securities products being offered
  • requiring registered representatives and their supervisors to complete specialized training in structured securities products before selling these products to customers
  • accurately listing structured securities products on customer statements
  • having controls to independently review their desk prices of structured securities products in the secondary market
  • having controls to adequately review the suitability of these products for customers
  • having controls to review customer concentrations in the structured securities products it sold

The staff report states that smaller retail broker-dealers should focus on:

  • the suitability of structured securities products recommended to retail customers
  • establishing, maintaining and enforcing proper supervisory procedures relating to suitability determination for purchasers of structured securities products
  • having adequate training for registered representatives who sell structured securities products and for their supervisors

Structured Notes

In January 2011, Bank of America Merrill Lynch, registered its Strategic Return Notes, structured notes designed to track a proprietary volatility index. The notes were marketed to the public beginning in approximately the fall of the 2010. The intended purpose of the financial instrument was to provide a hedge in the event that broader markets were to decline. Unbeknownst to its investors, the formula developed by Merrill Lynch’s alternative investments group was mathematically flawed and doomed to fail over time. Unfortunately, Merrill Lynch never disclosed to investors or their own financial advisors that if held to maturity, these notes would be worthless. These notes were of limited liquidity: early redemption was restricted and Merrill Lynch did not maintain an active secondary market.

FINRA Issues Member Notice

In January 2012, FINRA issued Notice to Members 12-03, among other things, reminding firms of their obligations with respect to the sale of these complex products, which present an additional risk to retail investors because its complexity adds a further dimension to the investment decision process beyond the fundamentals of market forces. FINRA also suggests that registered representatives of firms selling these products obtain specific training and that firms provide heightened supervisory and compliance procedures, and monitor the sale of these products in a manner that is reasonably designed to ensure that each product is recommended only to a customer who understands the essential features of the product and for whom the product is suitable.

Guiliano Law Group

Our practice is limited to the representation of investors in claims, for fraud in connection with the sale of securities, the sale or recommendation of excessively risky or unsuitable securities, breach of fiduciary duty, and the failure to supervise. We accept representation on a contingent fee basis, meaning there is no cost to unless we make a recovery for you, and there is never any charge for a consultation or an evaluation of your claim. For more information contact us at (877) SEC-ATTY.