Structural Complexity as a Cover for Fraud? Analyzing Losses from Exotic Structured Investment Products

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Investors in the twenty-first century face more options than ever before. Traditional vehicles like stocks, bonds, annuities, options, futures, and asset-backed securities have been joined by a broadening array of esoteric and novel structured investment products. It is now possible to earn a degree in “Financial Engineering,” a multi-disciplinary field that merges mathematics, statistics, economic theory, and computer modeling and applies it to the world of structured finance. Financial engineers conceptualize novel investment products, which are then underwritten by major Wall Street banks, rated by rating agencies, and brought to the market.

A number of exotic structured investment products have led to investors experiencing significant losses during the recent financial crisis. Such structured investment vehicles have included constant proportion debt obligations (CPDOs), return optimization securities, yield magnet notes, reverse exchangeable securities, and principal-protected notes.[1]

Structured Investment Product


Constant Proportion Debt Obligations (CPDOs)

A CPDO “is a fully-funded structured credit product.”[2] It consists of a special purpose vehicle that issues floating rate notes, which are purchased at par by investors. The proceeds received from investors are held in a cash account, as collateral for a long position in a portfolio of credit default swaps. A CPDO is leveraged, because “the notional size of the long position is a multiple of the size of the cash account.”[3]Typically, a CPDO has a ten-year maturity.

Return Optimization Securities (ROSs)

These structured notes “were supposed to perform like a basket of securities or an index such as the S&P 500. Unlike a stock index or currency basket, however, which could be subject to volatility and big swings, the returns on these investments would be capped, and in exchange for the cap, the investor was supposed to get built-in downside protection.”[4]

Principal-Protected Notes (PPNs)

A structured note with principal protection “refers to any structured product that combines a bond with a derivative component—and that offers a full or partial return of principal at maturity… Structured notes with principal protection typically reflect the combination of a zero-coupon bond, which pays no interest until the bond matures, with an option or other derivative product whose payoff is linked to an underlying asset, index or benchmark. The underlying asset, index or benchmark can vary widely from commonly cited market benchmarks to foreign equity indices, currencies, commodities, spreads between interest rates or “hybrid” baskets of various asset types… These products are designed to return some or all principal at a set maturity date—typically ranging up to 10 years from issuance. The investor also is entitled to participate in a return that is linked to a specified change in the value of the underlying asset.”[5]

Reverse Exchangeable Securities

Reverse exchange securities, also called reverse exchangeable notes, are short-term notes that are linked to an underlying stock, index such as an equity index, or a basket of indices. Reverse exchangeable notes are bonds that “pay a fixed interest rate and guarantee to return the investor’s initial investment after a specified period, unless the linked stock falls below a certain threshold. If that happens, the notes often pay back just a fraction of the original investment.”[6]

Yield Magnet Notes

Yield magnet notes are an equity-linked investment, with notes generally tied to a basket of specific stocks, which provide for the return of principal at maturity of the note. The variable coupon payments are determined based on the price performance of a portfolio of underlying stocks.[7] The notes provide for a combination of fixed coupon payments and variable coupon payments during the term of the notes. ‘Magnet’ features of the notes function to ‘lock in’ the price appreciation of the underlying stocks when certain performance criteria are met.

An analysis of these complex structured products has led one scholar to opine “that these products were designed so as to place buyers at a disadvantage to the investment banks that originated the products and the broker-deals that sold them.”[8] Australian Judge Jayne Jagot, who has handled a large case recently regarding claims against rating agencies related to constant proportion debt obligations, described those CPDOs as “grotesquely complicated.”[9]

Disputes stemming from losses from exotic structured investment products are making their way through the courts and before arbitrators. Despite their reassuring name suggesting preservation of principal, many investors have experienced substantial losses from principal-protected notes issued by entities such as Lehman Brothers.[10] FINRA has fined UBS Financial Services, Inc. $2.5 million and required it to pay $8.25 million in restitution for omissions and statements made that misled investors about principal-protected notes.[11]

In November 2012, Judge Jagot issued judgment against rating agency S&P, finding they were liable for the “AAA” ratings they assigned to constant proportion debt obligations arranged by ABN Amro Bank N.V. In that case, Bathurst Regional Council v. Local Government Financial Services &Ors (No. 5), the Court concluded that S&P failed to develop its own model to rate these structured products and instead simply adopted its client’s model without bothering to verify its underlying assumptions.[12]

The more complicated financial products become, the more important it is for investors to understand and assess risks before making investment decisions. At the same time, no matter how complicated the instrument, underwriters, sellers, and raters of structured investment vehicles may be held accountable for their representations and omissions. An instrument’s complexity is not an excuse for lack of transparency, for failing to fully disclose characteristics of the investments, for knowingly or recklessly using an untested ratings model, or for being reckless about a structured product’s risks.

In the unfortunate event that an investor experiences a significant loss from a structured investment product, it is essential that she have the expertise (or counsel and advisors with the expertise) to critically assess the circumstances of the underlying investment and loss. What representations were made by the underwriter and any rating entities about the investment vehicles and credit or liquidity risk? Were those representations accurate and complete? What assumptions were made by those bringing the structured products to market and rating the instruments, and were those assumptions made transparent to investors? What duties, if any, were owed by the sellers of the investment products and were those duties met?

While the financial meltdown may temporarily increase skepticism about structured investment products, it is likely that complex structured investment products will remain part of the financial market for the foreseeable future. Financial engineers are around to stay. At all stages of the investment process, investors should increase their financial literacy with structured investment products. If they face losses from complex structured products, counsel familiar with structured finance products can help them separate genuine structural complexities from potential fraud.

[1] Donald Richards and Hein Hundal, Constant Proportion Debt Obligations, Zeno’s Paradox, and the Spectacular Financial Crisis of 2008, June 13, 2012, available at; Donald St. P. Richards, Return Optimization Securities and Other Remarkable Structured Investment Products: Indicators of Future Outcomes for U.S. Treasuries?, March 27, 2013, available at
[2] Michael B. Gordy and Sren Willemann, Constant Proportion Debt Obligations: A Post-Mortem Analysis of Rating Models, Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, 2010-05, at 2, available at
[3] Id.
[4] Seth Lipner, UBS Having Hard Time with Lehman Structured Products Arbitration,, April 26, 2010, available at
[5] Securities and Exchange Commission, Structured Notes with Principal Protection: Note the Terms of Your Investment, June 2, 2011, available at
[6] Jean Eaglesham, Complex Bond Faces Regulators’ Scrutiny: ‘Reverse Convertible Notes’ Can Tumble Along With Stock, Wall Street Journal, March 31, 2011.
[7] Richards, Return Optimization Securities and Other Remarkable Structured Investment Products, at 6-7.
[8] Richards, Return Optimization Securities and Other Remarkable Structured Investment Products, at 2.
[9] Floyd Norris, A Casino Strategy, Rated AAA, NY Times, Nov. 8, 2012.
[10] Gretchen Morgenson, ‘100% Protected’ Isn’t as Safe as it Sounds, NY Times, May 22, 2010.
[11] FINRA News Release, FINRA Fines UBS Financial Services $2.5 Million; Orders UBS to Pay Restitution of $8.25 Million for Omissions That Effectively Misled Investors in Sales of Lehman-Issued 100% Principal-Protected Notes, April 11, 2011, available at
[12]Norris, A Casino Strategy, Rated AAA, NY Times, Nov. 8, 2012. A summary of Judge Jagot’s lengthy opinion in the Bathurst Regional Council case can be found at

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