Corporate & Securities Law

100% Principal Protected Notes Fail To Live Up To Their Hype

By Steven Caruso

Complex securities sold as 100% principal protected notes have failed to live up to their billing. In recent months, untold numbers of investors have witnessed billions of dollars in losses because of so-called investments that were touted by brokers as good as cash investments.

A May 21 article by Gretchen Morgenson in the New York Times highlights the questions surrounding 100% principal protected notes and how these complete securities became the darling of Wall Street and a disaster for many investors.

Principal protected notes are essentially zero-coupon notes whose return is partly tied to the performance of an equity index, such as the Standard & Poor?s 500 or the Russell 2000. How an investor makes money on these types of investments, however, is a complex process. The securities promise to return an investor?s principal, typically at the end of 18 months, along with the added gain from the index?s performance if that index trades within a certain range.

The tricky part is this: For an investor with one of these notes to earn the return of the index, as well as get his principal back, the index cannot fall 25.5% or more from its level at the date of issuance. The index also cannot rise more than 27.5% above that level. If the index exceeds those levels during the holding period, an investor would receive only his principal back.

As the New York Times article points out, 100% principal protected notes were sold by many brokerages to conservative investors who typically put their money in low-risk financial products like certificates of deposit. Many investors quickly became disenchanted with their decision to buy into principal protected notes, especially those who bought notes issued by Lehman Brothers Holdings. Those investments are now worth mere pennies on the dollar following the company?s bankruptcy filing in September 2008.

Two investors who lost big on 100% principal protected notes with Lehman were Corinne and Gregory Minasian, according to the New York Times. On the suggestion of their UBS broker they invested almost $100,000 - more than half of their savings - into Lehman notes in early 2008. They ultimately lost everything, and currently have an arbitration case pending in an attempt to recover their losses.

The Minasians contend their UBS broker failed to explain the risks in the securities, and never provided them with a prospectus. They contend they didn?t? even know their investment had been issued by Lehman Brothers until the firm actually collapsed in 2008.

?I am not a sophisticated investor,? said Mr. Minasian in the NYT?s article. ?Many years ago I dabbled in the stock market, but I learned my lessons. Over the past 10 to 15 years my wife and I invested in CDs.?

UBS sold $1 billion of these notes to investors. Commissions were 1.75%, a percentage that is far higher than those generated on sales of CDs. When Mr. Minasian asked about the commission, he says his broker said none existed.

Full post as published by Representing Investors on May 26, 2010 (boomark / email).