On 20th February 2012 it was reported that the UK Financial Services Authority (FSA) has fined Santander £1.5 million for failing to confirm the circumstances under which its structured products would be covered by the UK Financial Services Compensation Scheme (FSCS).
In the US, the law firm Gilman and Pastor LLP, states on their website that the firm “is representing persons and institutions who purchased Morgan Stanley structured investments which were represented as protecting investors’ full investments, from December 15, 2005 through the present date. Plaintiffs allege that Morgan Stanley and other parties deceived investors as to the risks of investing in the structured investments”.
In the Santander case, investors reportedly began to query to what extent they were covered by the FSCS towards the end of 2008, but it took the bank until January 2010 to clarify the position for investors. In the meantime it continued to sell £2.7 billion of structured products, even after it was alerted to the fact that two of the products had limited FSCS protection.
The FSA explained that the extent of FSCS cover is important to customers and so firms must be clear in the material they provide to clients. The fine is specifically in relation to breaches of the FSA handbook namely Principle 2 – skill, care and diligence in business, and Principle 7 – communication with clients.
I do not have sufficient detail on what has been alleged to have occurred with Morgan Stanley, however, both these examples illustrate that there are certain key points to remember when it comes to investing in structured products.
Structured products have been around for years and are commonly used to gain exposure to an asset class without taking the risk of investing in it directly. For example, a product which guarantees return of your money at the end of the term coupled with positive performance of stockmarket indices may have appeal to an investor who is looking to lock in gains already made from stockmarkets or for someone who wants to participate in the potential rise of stockmarkets without risking capital.
The market for these products has over the years evolved with a new breed of products emerging. Often the return of your original capital is contingent on a number of factors and are therefore known as ‘soft guarantees’. In the event that the product fails to achieve certain parameters then the investor does not get their full money back. Sometimes this can be evident from the terms on offer as they look too good to be true.
That said, I have also seen occasions where the potential rewards look particularly appealing and the product is truly capital guaranteed by the bank. However, all that glitters is certainly not gold and this can sometimes occur when the returns are contingent on an event that realistically is not likely to happen.
The acid test when looking at these investments is to consider it from the perspective of a bank. Generally speaking banks make profits by generating better returns than the pay their depositors. The obvious example is that lending rates are always higher than deposit rates – so, after costs the difference between the two is profit for the bank.
I have seen structured products being issued by banks that seem to promise returns of up to 12% per annum. The question that I ask is a simple one, in that if a bank is confident of offering a product giving up to 12% per annum, then why are they offering it to investors when they can keep all the profits themselves? After all, the last few years have demonstrated that banks are not charities.
There are many types of structured products on the market, and although some can appear similar at a glance, they can entail very different amounts of risk.
Where a structured product promises the return of your money even if the linked stockmarket index goes down, it will have a guarantor, usually a bank. The capital guarantee is dependent on this financial institution meeting its obligation, so it is important that you evaluate the covenant of the guarantor. The bank should be independently labeled as being credit worthy by a ratings agency like Standard & Poor’s or Moody’s
The moral of the story is that if you are looking at investing in a structured product you should ask your adviser to give you something in writing from the bank that confirms specifically how the product works and what is the potential downside.
By David Franks, Chief Executive, Blevins Franks
21st February 2012