Lehman Principal Protected Note Arbitrations On The Rise

Spurred by an enforcement proceeding by the State of New Hampshire and a class action complaint filed against Lehman Brothers executives, retail investors are retaining attorneys to attempt to recover their investment losses in Lehman Brothers. This article examines the potential for these cases, and the defense of same.

The Securities At Issue – Principal Protected Notes

These arbitrations involve Principal Protected Notes, a form of structured investments. Structured Investments link fixed income notes and CDs to the performance of equities, commodities, currencies or other assets.   These are not new products and have been in existence for years.

There are many types of structured investments, and the main distinctions are full or partial principal protection, payment of a variable amount at maturity, or payments by a coupon linked to a specific security or index with principal at risk. The customized risk and return profiles of structured investments can be suitable for many portfolios, with a wide range of available options.

These arbitrations involve a form of structure investments known as Principal Protected Notes (PPNs). PPNs are a hybrid-style security that includes elements of fixed income notes with derivatives. PPNs are usually linked to an equities index, group of indices or other assets. As the name suggests, PPNs aim to protect principal for investors who also seek potential gains in the equities linked or other indices. Most PPNs have a term of three to eight years, and are generally tied to the S&P 500, NASDAQ 100 and the Dow Jones Industrial Average.

At its most basic form, PPNs are unsecured promissory notes that are linked to a referenced security.Unfortunately, they were not always marketed in such a manner, and in recent years, these PPNs were presented to investors as being relatively safe investments.

Marketing of Principal Protected Notes to Retail Investors

Structured investments in general, and principal protected notes in particular, became popular in the last 5 years or so, and were presented by firms to retail investors as conservative investments, where the investor could receive a return based on a standard index, and be guaranteed the return of his principal if he held the investment to maturity.

FINRA recognized the popularity of these products in 2005, and noted that sales of these products were no longer being marketed only to institutional customers. FINRA issued a Notice to Members to provide guidance concerning the sale of structured products to retail customers.

In the NTM, FINRA expressed its concern that firms “may not be fulfilling their sales practice obligations when selling these instruments, especially to retail customers .”   In fact, FINRA cautioned its members that they should not “portray structured products as ‘conservative’ or a source of ‘predictable current income’ unless such statements are accurate, fair and balanced.”

Lehman Brothers PPNs and Bankruptcy

As an investment, there is nothing inappropriate in structured products in general, nor is there anything wrong with Principal Protected Notes. They are an accepted and recognized investment vehicle.These notes are principal protected, and no one disputes that. At maturity, the investor gets a return of its principal, from the borrower – in the instant case…Lehman Brothers.

And therein lies the problem – Lehman filed for bankruptcy, and suddenly the principal protector is no longer able to protect that principal – it is bankrupt. Making the situation worse, in the bankruptcy, these notes are unsecured, and lower in the creditor line than a secured note, although ahead of the common stock investor.

The Arbitration Filings

And that brings us to the present day. Brokers and brokerage firms sold the notes, investors purchased the notes, the markets continued to slide, Lehman got in trouble. Investors suffered significant losses, and are now looking to recover their losses. Estimates as to the dollar value of investments in structured products to $70 billion in 2006 and ballooned in 2007 to $120 billion, almost half of which was sold to individual investors, according to the Structured Products Association

Cases are being filed at an alarming rate. While the allegations are varied, the cases have a common theme – the marketing of the notes and the failure to make necessary disclosures to investors. Investor claims received some support in June of this year, when the State of New Hampshire instituted proceedings against UBS Financial Services, alleging that investors in New Hampshire lost $2.5 million in various structured products backed by Lehman Brothers, and that UBS engaged in “dishonest and unethical business practices,” by not adequately disclosing the risks involved in the investment.

UBS presented these notes as simple, safe investments when in fact they are highly volatile and are subject to shifting market conditions,” said Jeff Spill, the bureau’s deputy director for enforcement. “The safety of these products was exaggerated. We believe UBS engaged in unfair and unlawful sales practices when presenting these investments.”

These claims have a common theme, and focus on the disclosures, or lack of disclosures, that were made by the broker or the firm. While these cases are fact specific, they generally make the same types of allegations, including allegations that the firm, or the individual broker:

• represented the 100% Principal Protection Notes investment as being 100% principal-protected if held to maturity.
• represented that all of the other Principal Protection Notes were principal protected, as long as the underlying indices or basket did not decline in value.
• did not properly inform clients of the risks of each of the Principal Protection Notes, which included risk of Lehman’s default.
• did not inform its clients that Lehman’s financial position was declining and that the Principal Protection Notes could potentially decrease substantially, if not become worthless, as a result of Lehman’s financial position.
• promoted the Principal Protection Notes to investors who were seeking preservation of capital without fully disclosing the true nature of the risks involved.
• Did not disclose to investors that there was a risk of loss of the entire investment.

There are also allegations that some firms continued to recommend the sale of Principal Protection Notes in the spring of 2008, after the failure of the Bear Stearns. The legal theory is that the Bear Stearns failure should have highlighted the risk investing in financial institutions that held large positions in subprime mortgages, and that the banks were themselves decreasing their own Principal Protection Notes holdings, or risk exposure to Lehman generally, while still recommending investors to invest in or maintain their positions.

Naturally, these are only allegations, and need to be proven in a court or arbitration. However, if these firms were reducing their own positions in these types of securities while recommending the same or similar investments to their customers, the case becomes much more about securities fraud than the failure to disclose risks.

These cases are being filed, apparently at an alarming rate. According to FINRA’s arbitration statistics, as of June 2009 nearly 400 arbitration claims have been filed with FINRA for investment products categorized as “Derivative Securities” and suitability claims for the first half of 2009 were more than double the number of claims for all of 2006, and misrepresentation claims have more than tripled the number filed in 2006.

FINRA does not identify the firms or brokers who are being named in these cases, but UBS Financial Services is undoubtedly seeing its share of cases, as it was one of the firms who were actually creating these securities and selling them to its retail customers. Customers are also going to be filing claims against their individual brokers, as the broker, not the firm, made the actual representation regarding the securities. For brokers, this presents a significant problem as it is undoubtedly going to be the case that the brokers were not lying to their customers, they were conveying information from their firms; information that the broker undoubtedly believed, and that the broker had no reason to doubt.

We are continuing to review and investigate these claims, and will file updates as these cases progress. For more information, feel free to contact me at 212-509-6544 or 973-559-5566, or by email at astarita@beamlaw.com

Mark J. Astarita, Esq. is a partner in the securities law firm of Beam & Astarita, LLC.   Mr. Astarita has represented parties in over 500 securities arbitrations across the country over the past 27 years. Information regarding Mr. Astarita and Beam & Astarita, LLC is available at their web site, www.beamlaw.com