Record-Breaking FINRA Arbitration Award: Over $100 Million Awarded to Investors in Structured Notes Arbitration

In an unprecedented decision, a Financial Industry Regulatory Authority (FINRA) arbitration panel has awarded over $100 million in damages to investors who suffered significant losses after their brokers recommended investments in structured notes. The award included over $26 million in compensatory damages and $79 million in punitive damages. The total award is set to increase further, as the arbitration panel also granted interest and attorney’s fees amounting to 25% of the total compensatory damages. This landmark ruling underscores the substantial risks associated with these complex financial instruments and highlights the critical need for investors to understand what they are engaging in before committing their money.

Structured notes are hybrid securities that combine fixed-income assets with derivative components, offering returns linked to the performance of underlying assets such as equities, commodities, or interest rates. Issued primarily by major financial institutions, these products are marketed as providing customized investment strategies, sometimes promising enhanced returns or principal protection under certain conditions. However, their complexity and inherent risks make them challenging to evaluate, especially for retail investors.

At their core, structured notes consist of a debt or fixed-income instrument and a derivative component. The debt portion functions as a bond, typically issued by a bank or financial institution, which promises to return the principal at maturity—assuming the issuer does not default. This fixed-income component often provides little to no interest income, as much of the investment's value is tied to the derivative structure. The derivative component, which is typically an option or a series of options, determines the note’s return based on the performance of a referenced asset or index. This could be a stock index, a basket of securities, interest rates, or even volatility measures.

Importantly, some of the structured investments may offer full or partial market protection on the initial investment but with one important caveat: often, only if they are held to maturity.

There are many diverse structures and underlying assets that can be associated with structured notes, each carrying unique risk and return profiles. Below are just a few examples of these investments and how they might work:

Equity-Linked Note with Downside Protection

An investor enters into a five-year contract with a bank, investing $100,000 in a note linked to the S&P 500 index. The terms specify that at maturity:

• If the S&P 500 has increased, the investor receives their principal plus 80% of the index's gain.

• If the S&P 500 has decreased, the investor still receives their full principal, offering downside protection.

This structure allows participation in market gains while safeguarding against losses, though the upside participation rate is less than 100%.

Principal-Protected Note with Capped Gains

Consider a three-year note linked to a broad equity index, offering 100% principal protection and a maximum return capped at 7%. At maturity:

• If the index has increased by up to 7%, the investor receives a return equal to the index's gain.

• If the index's gain exceeds 7%, the return is still capped at 7%.

• If the index has decreased or remained unchanged, the investor receives only their principal.

This note provides full principal protection but limits potential returns.

Market-Linked Certificate of Deposit (CD)

A bank offers a five-year market-linked CD tied to the performance of a commodity index. Features include:

• FDIC insurance up to applicable limits, ensuring principal protection.

• Potential for returns based on the commodity index's performance over the term.

If the index performs well, the investor benefits from higher returns; if not, they still retain their principal, subject to FDIC insurance limits. These structured products can come with 100% floors (offering full protection of the invested principal) or partial floors (offering partial protection of the invested principal).  

Callable Yield Note with Conditional Coupons

An investor purchases a six-year callable yield note linked to a technology stock, offering:

• Quarterly coupon payments of 4% (16% annualized) as long as the index remains above 80% of its initial level.

• If the index falls below this threshold, no coupon is paid for that period.

• The issuer has the right to call (redeem) the note early, returning the principal plus any accrued interest.

This structure provides high-income potential but includes risks like missed coupons if the index declines and the possibility of early redemption by the issuer.

Currency-Linked Structured Note

An investor buys a two-year note linked to the exchange rate between the U.S. dollar and the euro. The note offers:

• Enhanced returns if the dollar strengthens against the euro beyond a predetermined threshold.

• Reduced or negative returns if the dollar weakens or doesn't appreciate sufficiently.

This type of note allows investors to speculate on currency movements but carries significant risk due to forex market volatility.

As the above examples demonstrate, structured notes can be designed to offer exposure to various market scenarios. However, their complicated structures and risk characteristics make them unsuitable for many retail investors. One of the risks is credit risk, as investors are exposed to the financial health of the issuing institution. If the issuer defaults, investors could lose their entire principal, regardless of how the underlying asset performed. Liquidity risk is another major concern. Unlike traditional stocks or bonds, structured notes are not always traded on secondary markets, making it difficult for investors to exit their positions before maturity without incurring substantial losses.

The most significant risk is their complexity. Structured note products are difficult for the average investor to fully understand, and their risk-reward profiles are often challenging to grasp. Many structured notes include features such as different levels of principal protection such as Full Floors or Partial Floors,  “knock-in” or “knock-out” clauses, which alter the payout structure based on specific market conditions. For example, a structured note linked to a stock index may offer enhanced returns if the index stays within a defined range, but if the index falls below a certain threshold, the investor could face severe losses. Or, a Structured Note CD may offer a higher potential for return when only partial principal protection is selected. These intricate details, often buried in lengthy prospectuses, can be easily overlooked or misunderstood by retail investors.

Market risk remains a crucial factor, as the return on structured notes is directly tied to the performance of the underlying asset. Sudden market volatility, economic downturns, or unexpected financial events can drastically alter the value of these investments, leading to outcomes far different from what investors initially anticipated. Many investors are lured by the potential for higher returns but fail to recognize that these products often carry hidden risks that can result in significant losses.

Given these characteristics, structured notes need to be carefully evaluated to determine whether they are a suitable investment for retail investors. FINRA has repeatedly warned about the risks of these products, emphasizing the importance of understanding their structure before investing. This caution mirrors the warnings issued for other complex investments, such as volatility-linked exchange-traded products, which we have discussed in previous blogs. Both structured notes and volatility-linked products share an inherent complexity that makes them difficult for the average investor to assess properly.

If you or someone you know has suffered financial losses due to investments in structured notes or other complex financial products, our legal team is here to help. At AMW Law, PLLC, we focus on representing investors in arbitration disputes involving unsuitable investment recommendations, inadequate risk disclosures, and other forms of broker misconduct. Our firm is committed to protecting investor rights and holding financial professionals accountable when they fail to uphold their duties.

Contact us today for a free consultation to explore your legal options and take the necessary steps to recover your losses. Understanding the risks associated with complex financial products is crucial, but when financial professionals misrepresent or fail to disclose those risks, investors have legal recourse. We are here to guide you through the process and advocate for your best interests.