The Securities Litigation Expert Blog

Premeditated "C" Share Churning at Morgan Stanley?

Posted by Jack Duval

Apr 5, 2018 10:06:49 AM

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On March 29, 2018, AdvisorHub broke a story about Morgan Stanley’s decision to convert all Class "C" mutual fund shares held for six or more years into load-waived "A" shares.  This is a beneficial move for clients, who will see their funds expenses ratios cut by about 1.5 percent.

Morgan Stanley brokers were not pleased with the move, which will reduce their 12b-1 fees from one percent to 25 basis points.

Some of them vowed to churn their clients in order to avoid the conversion.  (This was not an April Fool’s joke.)

Understanding “C” Share Mutual Funds

In theory, “C” shares are designed for clients who will be relatively short-term holders and want to avoid the front-end load on "A" shares and the back-end load on "B" shares.

In reality, they are an anachronistic holdover from the mid- to late-90's.  Back then, broker-dealers where trying to grow their fee-based business and saw "C" shares as a way for transactional brokers to become more annuitized.

Today, clients can get the same investment exposures at a fraction of the costs of "C" shares in ETFs, which are also much more tax-efficient.

The truth is that "C" share funds shouldn't be held for six years, and probably not at all.  Clients would be much better off in ETFs.  “C” shares have a full one percent 12b-1 fee charged annually to the customer in addition to the management fee and other expenses.  They are extremely high-fee and in almost all cases should be avoided.

Some "C" share mutual funds from other companies convert into "A" shares after 10 years, but again, 10 years in a “C” shares is unsuitable.

For a more detailed take on fees, see The Tyranny of High Fees blog post from our sister company, Bantam Inc.

Premeditated Churning                 

In what hopefully has Morgan Stanley CEO James Gorman losing sleep at night, AdvisorHub wrote:[1]              

Several Morgan Stanley brokers told AdvisorHub that they plan to "flip C shares, selling out of one fund into another's similar share class as they approach conversion date so that they can continue collecting the higher so-called 12b-1 fee, or trail.                                                  

"Losing 75 basis points on every six-year-old share on my team's book will cost us $300,000 in gross and $120,000 in commissions," lamented one broker, who said the team expects to "flip til the cows go home."

These brokers would be selling the "C" share funds before they convert into "A" shares, thus continuing the one percent 12b-1 fee instead of having it reduced to 25 basis points.          

This would be an unabashed churn of client accounts, and after a nine-year bull market, one that would likely have serious adverse tax consequences for the clients.

Belden Decision                       

The SEC has considered share class issues long ago and has clearly stated their position.  The share class most advantageous to the client must be purchased, or in this case, held.                      

In Belden, the SEC found that a broker buying "B" shares for a client who could have purchased load-waived "A" shares because of the amount to be invested, was violative of FINRA rules.  The Commission’s opinion stated:[2]

As we have frequently pointed out, a broker’s recommendations must be consistent with his customer’s best interests.  The test for whether Belden’s recommended investments were suitable is not whether Book acquiesced in them, but whether Belden’s recommendations to him were consistent with Book’s financial situation and needs.

FINRA concurs:[3]

NASD (now FINRA) construes Belden as supporting the principle that the manner of purchase of a recommended security by an associated person, where that security otherwise would be suitable based on the investor’s investment objectives, risk tolerance, and financial means, can render that recommendation unsuitable, and therefore violative of 2310 (now 2110), if there is an alternative basis upon which the security can be purchased to the pecuniary advantage of the investor.  (Emphasis added)

There is no way the selling of "C" shares to prevent them from converting into load-waived "A" shares can be in the customer’s best interest.

Supervision

Churning is the effectuating of any trade for the reason of making commissions.  Many churning claims involve high turnover (trading) of securities in a client account.  However, churning does not have to involve a series of trades.  Indeed, it can be one trade.

In the event a registered representative sells a “C” share fund before its conversion to a load-waived “A” share, it would constitute a one-trade churn.

Morgan Stanley supervisory systems should be able to flag any "C" share trades that occur close to a conversion, however, some brokers may preemptively sell "C" shares when they are further away from the six-year marker.

These will also be churns, but will very likely not be flagged.

Morgan Stanley supervisors should closely monitor all “C” share transactions for abuses.

_______

Notes:

[1]       Jed Horowitz; Morgan Stanley to Squeeze Mutual Fund Sales Compensation; AdvisorHub; March 29, 2018; Available at: https://advisorhub.com/morgan-stanley-to-squeeze-mutual-fund-sales-compensation/; Accessed April 4, 2018.

[2]       See Wendell Belden, Exchange Act Release No. 47859; May 14, 2003.

[3]       NASD NTM 03-69; Fee-Based Compensation; November 2003; 746 at footnote 5.

 

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Topics: C Share, Morgan Stanley, Churning, supervision, Wendell Belden, FINRA, Securities Exchange Commission

Protecting Senior Investors - 2nd Circuit Decision

Posted by Jack Duval

Mar 20, 2018 8:04:09 AM

 

Accelerant - Protecting Senior Investors.png

This blog post continues a series I began in 2012 highlighting regulatory efforts to protect senior investors.  (My previous blog posts on protecting senior investors can be found here.)

A recent 2nd Circuit decision is of interest to Broker-Dealers (“BDs”) implementing policies and procedures necessary to protect senior investors.

In brief, Claimant Alba T. Pfeffer filed a FINRA arbitration claim against Wells Fargo Advisors, LLC (“WFC”) and its Registered Representative Andre Mirkine.  The claim was based upon WFC and Mirkine’s refusal to transfer money from a trust account of Claimant Pfeffer’s husband that benefited their children to a trust account that benefited only Claimant Pfeffer.

“Mirkine explained that he did not transfer the assets because he became concerned following conversations with Mr. Pfeffer and Mr. Pferrer's son that Mr. Pfeffer was not competent and was being unduly influenced by Mrs. Pfeffer.  After receiving two letters from physicians opining that Mr. Pfeffer was not capable of making financial decisions, Wells Fargo froze both trusts."[1]

The FINRA arbitration panel denied all of Pfeffer’s claims.  Pfeffer then attempted to have the district court vacate the award and was there also denied.  Finally, Pfeffer appealed the district court’s decision to the 2nd Circuit Court of Appeals, which affirmed the district court’s ruling.[2]

There are a number of interesting items in the 2nd Circuit’s decision.

Refusing to Transfer Client Funds

Primarily, the decision to affirm the district court's denial of the vacature claim should bolster BDs in their efforts to protect senior investors.  It appears that WFC broker Mirkine and WFC supervisors did their job well by making a decision that would leave them open to potential litigation - refusing a request from an account holder to transfer money.[3]

This goes directly to FINRA Rule 2165 - Financial Exploitation of Specified Adults, which "provides a safe harbor for a member to place a temporary hold on a disbursement of funds or securities from the account... if the member reasonably believes that financial exploitation of the specified adult has occurred, is occurring, has been attempted or will be attempted."[4]

Manifest Disregard of the Law and Evidence?

Secondarily, the 2nd Circuit wrote:[5]

"On appeal, Mrs. Pfeffer argues that the award was procured by undue means, evident partiality, and misconduct because the Panel was intimidated by defense counsel and refused to consider relevant evidence.  She alleges that the Panel exhibited manifest disregard for the law and facts…

This Circuit does not recognize manifest disregard of the evidence as proper ground for vacating an arbitration panel's award and will only find a manifest disregard of the law where there is no colorable justification for a panel's conclusion."  (Emphasis added)

The 2nd Circuit found that the FINRA panel did not disregard evidence.  However, the fact that manifest disregard of evidence is not proper ground for vacating an award is bracing.

Finally, the 2nd Circuit sets the “manifest disregard of the law” standard so low at “no colorable justification” that it would seem highly remote to meet it.

Supervision

While it is no trivial matter to stop client distributions, supervisors should take quick action to stop suspect activity and to seek input from medical professionals and, if necessary, make referrals to law enforcement.

----------

Notes:

[1]       United States Court of Appeals for the Second Circuit; Summary Order; Alba T. Pfeffer Plaintiff-Appellant v. Wells Fargo Advisors, LLC, et al. Defendants-Appellees; 17-1819-cv; February 15, 2018; 3.  Available at: http://caselaw.findlaw.com/us-2nd-circuit/1889422.html; Accessed March 20, 2018.

[2]       Plaintiff Pfeffer was pro se for all three proceedings.

[3]       The FINRA panel denied Respondent Mirkine’s request for expungement of his CRD records and applied all forum fees to Respondent WFC.  This could indicate the Panel’s displeasure with some aspect of Respondent’s actions, however, without a reasoned award this is speculation.  See FINRA Award at: https://www.finra.org/sites/default/files/aao_documents/15-00294.pdf; Accessed March 20, 2018.

[4]       See FINRA Rule 2165 FAQs; Available at: http://www.finra.org/industry/frequently-asked-questions-regarding-finra-rules-relating-financial-exploitation-seniors; Accessed March 20, 2018.

[5]        See Supra Note 1 at 4-5.

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Topics: Protecting Senior Investors, Senior Investors, fraud, Elder Abuse, dementia, Alzheimer's, supervision, financial exploitation, 2nd Circuit

Leveraged and Inverse ETFs - Tracking Error

Posted by Jack Duval

Mar 12, 2018 8:07:34 AM

This blog post continues a series exploring leveraged and inverse ETFs.  Our previous posts can be read here and here.

February was a volatile month for the S&P 500.  Leveraged and inverse ETFs that track the S&P 500 saw volatility commensurate with their leverage.  However, compared to their un-leveraged peers, the major leveraged and inverse ETFs did not track the market closely.

Because of the constant leverage trap, we know that leveraged and inverse ETFs are forced to buy high and sell low on a daily basis.  This, plus the management fees of the funds, essentially lock in losses.

On a day to day basis, these factors are de minimis.  Over time, they are fatal.

Table 1: Leveraged and Inverse ETF Performance - February 2018

Screen Shot 2018-03-12 at 7.44.04 AM.png

Source: Bloomberg

As can be seen in Table 1, all the ETFs underperformed.  The underperformance increased with leverage and being directionally wrong.

As with all investments, volatility hurts returns.  For investors in leveraged and inverse ETFs, volatility leads to significant underperformance even over short holding periods.

Because of this complexity risk, these products are only suitable for sophisticated investors wishing to speculate by day trading or for one-day holding periods.

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Topics: suitability, Complexity Risk, Tracking Error, Leveraged and Inverse ETF

Jack Duval Launches RIA Firm Bantam Inc.

Posted by Jack Duval

Mar 4, 2018 7:28:11 AM

Bantam Logo Web-07.png

 

I'm pleased to announce the official launch of Bantam Inc. a registered investment advisory firm.

Bantam is brining a new level of fiduciary guidance to our clients for all aspects of their finances and investments.

A number of traits set Bantam apart:

  • Flat-fee pricing;
  • Ability to consult with clients on stand-alone projects without them having to move their assets;
  • Bantam is registered as a New York benefit corporation.  This means the firm is fiduciary bound at the advice level (as an RIA) and at the corporate level (as a benefit corporation).

To learn more, please visit the Bantam website.

As a side note, I am still very much in the litigation consulting business and will be taking cases for the foreseeable future.  Please feel free to reach out to discuss Bantam or potential cases.

Careers

I am in the process of hiring an investment advisor. I'm looking for someone who wants to join a dynamic startup and can grow with the firm.  The position would include salary, bonus, and equity that vests over time.

If you know anyone with a legal and/or accounting background, who is interested in working with high- and ultra-high net worth investors on complex problems, please forward their names to me.

We are securing office space in Manhattan, close to Grand Central Terminal.  More information is available on our Careers page.

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Topics: Bantam Inc.

Protecting Senior Investors - Nationwide Elder Fraud Sweep

Posted by Jack Duval

Feb 27, 2018 7:49:13 AM

Accelerant - Senior Investors DOJ Image-1.jpeg 

This blog post continues a series I began in 2012 highlighting regulatory efforts to protect senior investors.  (My previous blog posts on protecting senior investors can be found here.)

On February 22, 2018, the Justice Department announced a nationwide sweep that resulted in over 200 criminal charges for financial crimes targeting the elderly.

Attorney General Jeff Sessions was quoted, saying:

The Justice Department and its partners are taking unprecedented, coordinated action to protect elderly Americans from financial threats, both foreign and domestic... Today's actions send a clear message:  we will hold perpetrators of elder fraud schemes accountable wherever they are.  When criminals steal the hard-earned life savings of older Americans, we will respond with all the tools at the Department's disposal - criminal prosecutions to punish offenders, civil injunctions to shut the schemes down, and asset forfeiture to take back ill-gotten gains.

Today is only the beginning.  I have directed Department prosecutors to coordinate with both domestic law enforcement partners and foreign counterparts to stop these criminals from exploiting our seniors.

The Perpetrators

As I have written about before, many of the perpetrators were known to the victims.  The DOJ press release gave this description:

The actions charged a variety of fraud schemes, ranging from mass mailing, telemarketing and investment frauds to individual incidences of identity theft and theft by guardians.  A number of cases involved transnational criminal organizations that defrauded hundreds of thousands of elderly victims, while others involved a single relative or fiduciary who took advantage of an individual victim.  (Emphasis added)

While few crimes could be more heinous than those targeting senior investors, those perpetrated by guardians, relatives, or fiduciaries would qualify.

Supervisory Implications

The financial abuse of senior investors is not an isolated problem.  The DOJ press release stated that the schemes undertaken by the alleged criminals caused more than $500 million in losses to over a million victims.  

These sweep results should be a call to action to broker-dealers, RIA firms, and banks across the country to raise their supervisory oversight of senior investors accounts.

In the past, there has rightfully been significant focus on cases that involve senior investors with Alzheimer's or dementia.  However, unsophisticated and wholly trusting senior investors, who do not have the wherewithal to question recommendations, can also be subject to abuse by unscrupulous advisors.

Compliance and supervisory personnel at all financial firms need to be aware of the potential for abuse and should have special policies and procedures in place to monitor the activity in the accounts of senior investors.  At a minimum, these policies and procedures should detect financial fraud such as: unnecessary trading, unsuitable investments, and suspicious withdrawals.

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Topics: Protecting Senior Investors, Senior Investors, fraud, Elder Abuse, dementia, Alzheimer's, supervision, financial exploitation, Justice Department

Volatility-Linked Products - Complexity Risk Strikes Again

Posted by Jack Duval

Feb 6, 2018 10:41:24 AM

This blog post continues a series exploring volatility-linked exchange-traded products.  Our previous posts can be read here, here, and here.

The VIX S&P 500 volatility index ripped higher by 115 percent yesterday.  This effectively destroyed most, if not all, inverse VIX ETPs.

Common sense will inform that if an index increases by more than 100 percent, an investment vehicle designed to give the opposite (inverse) performance should decline to zero.  (In most cases, if an investment doesn't use leverage, a potential loss is limited to 100 percent.)

Indeed, experience is now bearing this out.

VelocityShares Inverse VIX Short Term ETNs (XIV)

The XIV ETN halted trading yesterday and fund manager Credit Suisse is almost certain to close the fund.

The prospectus language allows Credit Suisse to shutter the fund if the Intraday Indicative Value is equal to or less than 20 percent of the prior day's Closing Indicative Value (among other reasons).  That has happened.

Table 1: XIV Indicative Value

XIV - Indicative Value.gif

Source: Bloomberg

The XIV Indicative Value collapsed from 108.37 to 4.22, a 96 percent decline, and well under the 20 percent threshold.

The difference in the XIV price and indicative value was widening over the past few days of the market selloff, and then blew out yesterday.

Chart 1: XIV Price and Indicative Value

XIV Price v. XIV Indicative Value Chart.gif

Source: Bloomberg

Unfortunately, a significant amount of hot money had been flowing into this ETN due to it's returns over the past few years.  The XIV market cap was just off its all-time high, at $1.48B yesterday.

Chart 2: XIV Historical Market Cap

XIV Market Cap Chart.gif

Source: Bloomberg

A Bitter Irony

In a classic example of complexity risk, investors who bought the XIV at the close yesterday (thinking that the VIX had risen too far, too fast), will be wiped out, just like longer term holders.

As of this writing at 10:20am, the XIV is down 31 percent, meaning that those buyers would have been directionally correct, but will suffer virtually complete losses anyway with no chance to get out.

Suitability and Supervision of Volatility-Linked Products

For years, investors have been seeing their principal destroyed as unknowing advisors bought and held inverse and leveraged ETPs.  Indeed, the XIV prospectus (PS-16) gives this warning:

Screen Shot 2018-02-06 at 9.16.52 AM.png

Advisors putting their clients into inverse and leveraged ETPs should have known about the risks of long-term holding and the risk of complete overnight ruin.

Likewise, firms that allowed their advisors to sell these products should have implemented special training for them.  Furthermore, specific policies and procedures should have been written to insure these products were only utilized in speculative accounts, and for sophisticated investors, who were aware of, and accepted the risk of, total loss.

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Topics: suitability, Complexity Risk, supervision, Complex Investments, volatility-linked products, XIV, VelocityShares Inverse Short Term ETN

Protecting Senior Investors - FINRA FAQs

Posted by Jack Duval

Jan 17, 2018 7:48:00 AM

 

accelerant - senior investor fraud.jpg

 

This blog post continues a series that I began in 2012 highlighting regulatory efforts to protect senior investors.  (My previous blog posts on protecting senior investors can be found here.)

On January 3, 2018, FINRA posted guidance in the form of Frequently Asked Questions (“FAQs”) relating to protecting senior investors.

They did this in advance of FINRA Rule 2165 – Financial Exploitation of Specified Adults and Rule 4512 – Customer Account Information becoming (respectively) effective and amended on February 5, 2018.  Both rules were approved by the SEC in March 2017 and discussed in FINRA RM 17- 11.

I summarize and discuss a few of the more important points made in the FAQs and how they relate to account supervision.

Rule 2165 – Financial Exploitation of Specified Adults[1]

Q.1.1. May a member place a temporary hold on a securities transaction pursuant to Rule 2165?

A. Rule 2165 provides a safe harbor for a member to place a temporary hold on a disbursement of funds or securities from the account of a specified adult if the member reasonably believes that financial exploitation of the specified adult has occurred, is occurring, has been attempted or will be attempted. (Emphasis added)

This FAQ illustrates one of the key deficiencies with Rule 2165, that trading may continue in accounts where financial exploitation is occurring.  This is especially relevant to instances where the perpetrator of the exploitation is the Registered Representative.  In these instances, the Registered Representative could generate excessive compensation for herself without triggering a red flag under Rule 2165.  Indeed, it is conceivable that abusive trading could occur even if the account was under a temporary hold.

In these instances, the Registered Representative would be making withdrawals from the account through the broker-dealers own compensation mechanism.

An example of this could be the selling of a long-held low cost basis stock and using the proceeds to buy a high commission products.  The Registered Representative would get paid twice, once on the stock sale and once on the product purchases.  The payment of the commissions would not be reflected as a “disbursement of funds” and thus not flagged by a compliance system.

This scenario is not far-fetched.  I have seen cases where Registered Representatives have churned accounts after the client has died.

Supervisors must know the clients and their accounts well enough to detect abuse by Registered Representatives.

Q.1.2 Under Rule 2165, may a member that has a reasonable belief of financial exploitation of a Specified Adult regarding a disbursement or disbursements place a temporary hold or restrictions on an entire account if the member permits legitimate disbursements from the account?

A. FINRA has stated that, where a questionable disbursement involves less than all assets in an account, a member should not place a blanket hold on the entire account. Each disbursement should be analyzed separately.  (Emphasis added)

Here FINRA wants to avoid the failure of paying of legitimate bills and other disbursements even if a temporary hold has been placed on the account.  This would require significant diligence from the supervisor and Registered Representative to insure the disbursements were legitimate.

Rule 4512 – Customer Account Information[2]

Q.3.2. does the requirement in Rule 4512(a)(1)(F) to make reasonable efforts to obtain the name and contact information for a trusted contact upon the opening of a non-institutional customer’s account or when updating account information for an existing non-institutional account apply to all non-institutional accounts?

A. Rule 4512(a)(1)(F) provides that the trusted-contact provision “shall not apply to an institutional account”.  Accordingly, the trusted-contact provision applies to any account that does not meet the definition of an “institutional account” in Rule 4512(c), including accounts of non-natural persons that do not meet the definition.

FINRA defines an “institutional account” as:[3]

(1)  A bank, savings and loan association, insurance company or registered investment company;

(2) An investment adviser registered either with the SEC under Section 203 of the Investment Advisers Act or with a state securities commission (or any agency or office performing like functions); or

(3) Any other person (whether a natural person, corporation, partnership, trust or otherwise) with total assets of at least $50 million.

The key provision of this guidance is that member firms should try to obtain trusted contact information for all accounts, including entities such as trusts, corporations, and partnerships.

Also, in my experience, even if a client meets the “institutional” account criteria by having assets of $50 million or greater, they are just as subject to potential abuse as anyone else.  Furthermore, having more assets does not imply greater sophistication or protection from bad actors.

Supervisors should monitor these accounts with the same diligence as they do other accounts.

Q.3.4. When is a member required to seek to obtain the trusted-contact information for accounts in existence prior to the effective date of the amendments to Rule 4512 (“existing accounts”)?  When is a member required to update the trusted-contact information?

A. Consistent with the current requirements of Rule 4512(b), a member would not need to seek to obtain the trusted-contact information for existing accounts until such a time as the member updates the information for the account either in the course of the member’s routine and customary business or as otherwise required by applicable laws or rules.

Since knowing the client is an ongoing duty[4], asking clients for trusted contact information should be done at least as soon as the next contact with the client.  Client contact could be when making a trade recommendation, when presenting an account review, or for other reasons.

Q.4.1.  What is a member allowed to disclose to the trusted contact about a customer’s account?

A. Supplementary Material .06(a) to Rule 4512 requires that, at the time of account opening, a member disclose in writing (which may be electronic) to the customer that the member or an associated person is authorized to contact the trusted contact and disclose information about the customer’s account to address possible financial exploitation, to confirm the specifics of the customer’s current contact information, health status, or the identity of any legal guardian, executor, trustee or holder of a power of attorney, or as otherwise permitted by Rule 2165.[5]

… A member also could reach out to a trusted contact if it suspects that the customer may be suffering from Alzheimer’s disease, dementia or other forms of diminished capacity.

The disclosures should be limited to what the trusted contact would need to know to help make a determination as to any suspected exploitation or diminished capacity.  In most instances, it would not be necessary to disclose the total account value and details about a client’s investments with the trusted contact.

In the case of suspected possible financial exploitation, the focus would likely be on distribution requests.  If diminished capacity is suspected, no financial information would need to be disclosed, unless it was part of the indicia of the diminished capacity.

_________________

Notes:

[1]       Frequently Asked Questions Regarding FINRA Rules Relating to Financial Exploitation of Seniors;  January 3, 2018; Available at: http://www.finra.org/industry/frequently-asked-questions-regarding-finra-rules-relating-financial-exploitation-seniors; Accessed January 15, 2018.

[2]       Id.

[3]       FINRA Rule 4512 – Customer Account Information; Available at: http://finra.complinet.com/en/display/display.html?rbid=2403&element_id=9958; Accessed January 16, 2018.

[4]       See FINRA Rule 2111 – Suitability, regarding client profiling, and FINRA Rule 2090 – Know Your Client regarding diligence in the maintenance of client accounts.

[5]       FINRA also confirms that disclosures of financial information to a trusted contact would not be in violation of Regulation S-P (the SEC’s Privacy of Consumer Financial Information rule), since any disclosures would have been made with the customer’s consent.  See Regulation S-P Final Rule, available at: https://www.sec.gov/rules/final/34-42974.htm.  Accessed January 17, 2018.

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Topics: Protecting Senior Investors, Senior Investors, fraud, Elder Abuse, dementia, Alzheimer's, supervision, financial exploitation

Jack Duval Quoted in MarketWatch Article on CoCo Bonds

Posted by Jack Duval

Jan 2, 2018 10:46:12 AM

Accelerant Managing Partner Jack Duval was quoted in a MarketWatch article on contingent convertible ("CoCo") bonds.

What the article didn't mention is that Deutsche Bank and other CoCo issuers have been exploring making a market in total return swaps on CoCo's, including those issued by themselves.  If implemented, these derivitives would set up highly complex and perverse incentives where the bank (as counterparty) could profit from weakening it's own financial strength.

Banco Popular Bail-In

In a pattern that is repeated frequently in securities markets, in early- to mid-2017 Banco Popular common equity declined 80 percent while the Banco Popular 8 1/4 perpetual CoCo's only declined 20 percent.  This relationship existed until a month before the CoCo's were wiped out in the reorganization, thus "bailing-in" the bank by being completely written off.

Banco Popular CoCo v. Common Equity Chart.gif

Source: Bloomberg

Suitability of Complex Products

As I have discussed here and here, contingent convertible bonds are highly complex and subject to extraordinary risks that are not typical of traditional bonds.  They are only suitable for highly sophisticated investors who can evaluate the company specific and regulatory risks and are willing to lose their entire investment.  This eliminates virtually all retail investors and most institutional investors.

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Topics: CoCo, Contingent Convertible Bond, Banco Popular, Bail-in, MarketWatch

The Accelerant Arbitration Market Indicator - December 2017 Update

Posted by Jack Duval

Dec 18, 2017 11:09:30 AM

The Accelerant Arbitration Market Indicator was 2.37 at the end of October.  This is another new all-time high.  Complacency rules the markets as investors embrace risk assets with perceived impunity.

New FINRA arbitration claim filings continue to run at cycle-lows, as they have for the past four years. The current annualized rate is 3,418 for 2017.  

Historically, high readings from this indicator have presaged market declines.

 

 AAI + Forward Return-3.jpg

FINRA Arbitration Claims v. S&P 500-3.jpg

 

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Topics: Jack Duval, Accelerant Arbitration Market Indicator, FINRA Arbitration, Securities Expert

Volatility-Linked Products - Bank of America Strategic Return Notes

Posted by Jack Duval

Dec 1, 2017 10:07:27 AM

This blog post continues a series exploring volatility-linked exchange-traded products.

In this post, I examine the Bank of America Strategic Return Notes Linked to the Investable Volatility Index (“SRNs”), which were issued on November 23, 2010 and matured on November 27, 2015.

The SRNs were supposed to offer investors exposure to a volatility index over a five-year period.  However, due to high upfront and ongoing annual fees and the negative roll yield (previously discussed here and here), the investment resulted in almost a complete loss.

What is remarkable is that anyone who understood volatility products and negative roll yield would have known this ex-ante, that is, before the product was brought to market.  This is an example of how complexity risk manifests itself in investments, the people who created the investment didn’t understand it.

Disclosures, Negative Roll Yield, and Principal Destruction

The SRN Pricing Supplement lists the two percent upfront fee and the 0.75% annual internal fee as costs but does not mention the negative roll yield as a cost.  This is remarkable given that the negative roll yield is the primary cost of the strategy as it was to be implemented.

There was one disclosure in the SRN Pricing Supplement (on page 14) which addressed the negative roll yield (however, the phrase “negative roll yield” was not used):[1]

If the level of forward implied volatility is higher in the more distant S&P 500 Index options expirations months than it is in the nearer expiration months, then the level of the Index could be adversely affected as the Index positions are rebalanced daily to maintain a constant maturity.  The rebalancing involves increasing exposure to more distant forward implied volatility and decreasing exposure to more near-term forward implied volatility which may decrease the payment you receive at maturity or upon exchange.  Historically, the more distant expiration months have typically had a higher level of forward implied volatility than the nearer expiration months.

This explanation does not make it clear that the negative roll yield will be an almost certain daily destroyer of the investor’s principal.  Given the five-year term of the investment, the negative roll yield, coupled with the two percent up-front fee, and the 0.75% annual internal fee are virtually guaranteed to result in a catastrophic loss to the investor.

Of course, that is what happened.  The SRN’s were issued at $10/share and matured at $0.50/share.[2]  A 95 percent loss.  The negative roll yield was costing between four and 12 percent per quarter in 2011.[3]

Complexity Risk

This is a classic example of complexity risk, which I have written about extensively here and here.  Merrill Lynch broker Glen Ringwall was quoted saying:[4]

The roll costs are far larger than we ever understood or were disclosed to us…  This is borderline crooked.

To Mr. Ringwall’s point, if we assume that the negative roll yield was four percent per quarter that equals 16 percent per year.  Apply that over the five-year term of the SRNs and you get an 80 percent decline in principal.  Add the 5.6 percent total term costs from the front-end load and the ongoing management fees and the SRN is programmed to decline by 85.6 percent over its lifetime (assuming no movement in the underlying index).  Put another way, the underlying index would need to have and 85.6 percent return just to break even.

It is hard to believe that anyone associated with the SRNs creation understood these economics.  It appears that the brokers who sold it certainly did not understand.  And I can assure you that not one client who was sold the SRNs understood them.

DIY Client Due Diligence

In fairness, the SRN Annex to the Pricing Supplement did provide these user-friendly explanations what would help clients understand how to calculate the negative roll yield themselves:[5]

 

Screen Shot 2017-12-01 at 8.16.17 AM.png

Screen Shot 2017-12-01 at 8.16.29 AM.png

Screen Shot 2017-12-01 at 8.16.45 AM.png

Obviously, no client is working through these equations.

The written and formula disclosures above illustrate the primary point of investment complexity risk:  the more complex an investment is, the more likely it is to behave in ways that are unexpected.

This is the reason why complexity should generally be avoided and even sophisticated institutional investors should have a complexity risk budget to track and limit their exposures.

Supervison

As I have discussed in my previous posts, there are other volatility products such as the iPath VXX ETN trading today that have the same internal negative roll yield dynamics.

Supervisors must be knowledgeable about these investments and how they are not meant to be held longer than one day.  Supervisory policies and procedures should be implemented to insure that any holding periods longer than one day are flagged in exception reports and remedied immediately.

_________________

Notes:

[1]       Strategic Return Notes Pricing Supplement; PS-14.

[2]       Jean Eaglesham, The Wall Street Journal; SEC Readies Case Against Merrill Lynch Over Notes That Lost 95%; Available at: https://www.wsj.com/articles/sec-readies-case-against-merrill-over-notes-that-lost-95-1466544740; Accessed December 1, 2017.

[3]       Id.

[4]       Id.

[5]       Strategic Return Notes Pricing Supplement; Annex A; A1-2.  I have only produced part of them here.

For information about securities expert Jack Duval, click here.

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Topics: suitability, Complexity Risk, supervision, Complex Investments, volatility-linked products, negative roll yield

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