Structured products are extremely complex investment instruments. Structured products also come in many different varieties and can be sold directly to investors or embedded in mutual funds. Brokerage firms and registered investment advisory firms, or RIAs, regularly recommend these investments to clients claiming that structured products are conservative investments that generate current income and carry a high credit rating.
At their core, structured products are all market linked derivative investments. A structured product generally references a source against which market risk is taken. The source can be a single security, a basket of securities such as a market index, commodities, or a real estate loan portfolio. The variety of products that can be structured demonstrates the difficulty in formulating a single unified definition of a structured product. In addition to the variety of sources of market risk exposure, many structured products also have leverage features or may set risk limits sometimes referred to “principal protection.”
The United States Securities and Exchange Commission, or the SEC, defines structured products in Rule 434 which states that the contours of structured products are dependent on indices that have embedded in them forwards or options.
The clearer definition of structured products can be found in FINRA’s notice to members 05-59 which defines structured products as securities derived from a basket of securities or a single security, a commodity or a basket of securities. There a variety of structured products in the market today. However, the market reached its height in 2007 right before the great American recession.
In recent years, these products are making a comeback embedded in products sold to retail investors, like mutual funds. Certain structured products, such as structured mortgage backed securities (MBS) and collateralized debt obligations (CDO) cannot be sold directly to retail investors but can be purchased by investment advisers and sold to investors through mutual funds or other investment vehicles. Structured MBS and CDOs tranche credit loans into slices in order to apply leverage and increase returns along with risk. A key goal of the tranching process is to create classes of securities whose credit ratings are higher than the average credit rating of the underlying loans. The credit rating agencies have had real problems evaluating the true credit viability of these firms over the last ten years.
Brokerage firms have an obligation to perform a reasonable basis suitability determination before recommending structured products to investors. In order to ensure that the structured product is suitable, firms must ensure that the investment is priced so that the potential yield is appropriate in relation to the volatility of the referenced asset based upon comparable or similar investments, in terms of structure, volatility, and risk in the market. Many brokerage firms that sale structured products fail to disclose the risks of these products to their clients. Many of these products have opaque risks, lack liquidity due to a host of issues including the customized nature of the investment class, and as always, structured products are subject to the credit quality of the issuer of the structured product. If the issuer of the structured product fails, then the structured product will likely lose most of its value as will the investments that retail customers purchase that contain the structured product.
Prior to recommending structured products, or the mutual funds that contain structured products, brokerage firms must fully understand the risks and the contours of these investments. Firms must also ensure that the structured product is suitable for the individual investor based upon the investor’s investment objectives.
Gana Weinstein LLP has led the charge against brokerage firms that sell structured products to unwitting investors. Gana Weinstein has represented hundreds of investors who have been subject to the unsuitable sale of structured products. If you believe you were sold an unsuitable investment in structured products, then you should contact our law firm immediately. You can reach us day or night by phone or email. Our phone number is 800-810-4262 and our email is email@example.com.