Bloomberg News

State Regulators in U.S. Combine to Probe Structured-Notes

October 24, 2011

(Updates with lawyer’s comment in seventh paragraph.)

Oct. 24 (Bloomberg) -- State regulators in the U.S. are combining forces to investigate whether brokers improperly sold structured notes, securities that package debt with derivatives that are typically offered to individual investors.

About 10 states including Florida, Texas, New Hampshire and Missouri are examining whether the debt instruments were marketed without adequate disclosure of their risks, said Franklin L. Widmann, head of the structured products working group for the North American Securities Administrators Association.

“It’s not clear to us that people who invested in these products in certain circumstances even realized the risks,” Widmann, who’s also director of securities for Florida’s Office of Financial Regulation, said Oct. 21 in a telephone interview. He declined further comment about the ongoing investigation.

Florida joined Massachusetts and Georgia in July in probing sales of structured notes such as reverse convertibles, which convert into stock if a company’s shares plummet. The “complex” securities can be difficult for investors and brokers to evaluate, according to a July 25 statement from the Financial Industry Regulatory Authority.

Sales are poised to match last year’s record $49.5 billion as investors frustrated by record-low interest rates on savings seek higher returns through riskier investments. Issuance rose 46 percent last year from 2009, according to data compiled by Bloomberg.

Unsupported Prices

As sales have grown, brokers may have taken advantage of some individual investors when selling the notes, the Securities and Exchange Commission said in July. Brokers sold the securities, which are marketed as high-yielding alternative investments, at “disadvantageous” and unsupported prices and didn’t disclose fees, according to the SEC report, based on a sweep that examined the operations of 11 broker-dealers, including three large firms associated with banks. The U.S. regulator didn’t name the companies.

“There’s already been so much scrutiny in this area that the states’ efforts won’t likely cause meaningful reaction from market participants,” said Steven Scholes, a Chicago-based partner at McDermott Will & Emery LLP, and a former attorney in the SEC’s enforcement division.

UBS AG, Switzerland’s largest bank, agreed to pay $1 million in August to settle allegations by New Hampshire that it misled investors when selling structured products backed by Lehman Brothers Holdings Inc.

Improper Sales

Banco Santander SA, Spain’s largest bank, and two brokerage firms were fined by Finra for improper sales of reverse convertibles. In April, Santander Securities was fined $2 million to resolve U.S. regulatory claims that its Puerto Rico- based brokerage improperly sold risky structured financial products to individual investors including the elderly. Santander declined to comment at the time.

Ferris, Baker Watts LLC, which was acquired by Royal Bank of Canada in 2008, was ordered to pay $690,000 in October 2010 to resolve Finra claims that it failed to supervise reverse- convertible sales. H&R Block Financial Advisors Inc., acquired by Ameriprise Financial Inc. in 2008, was fined $200,000 for a lack of supervisory systems in February 2010. Neither firm admitted wrongdoing.

--With assistance from Zeke Faux in New York. Editors: Mitchell Martin, Pierre Paulden

To contact the reporter on this story: Matt Robinson in New York at mrobinson55@bloomberg.net

To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net.


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