Investors in so-called “auto-callable” notes links to stocks may have FINRA arbitration claims, if their investment was recommended by a stockbroker or financial advisor who lacked a reasonable basis for the recommendation, or if the nature and risks of the investment were misrepresented.
“Auto-callable” notes are structured products that are often sold as higher-yielding alternatives to bonds, which obscures the fact that investors’ potential losses are much larger and much more likely to occur than in a bond investment. But during the years 2020-22, when record low interest rates prevailed, sales of “auto-callable” notes skyrocketed, peaking at $40.1 billion in 2021. Desperate for income, investors were often sold these notes based on a sales presentation that focused on yields approaching 10% a year.
But these high stated yields can be misleading for a simple reason- the investor actually receives the stated and advertised yield only under certain conditions. If the price of the referenced stock rises above the referenced stocks price at the time of issuance, the notes are “auto-called” and the income yield ceases. By called, it is meant that the note is bought back from the investor by issuer. Once the note is called the investor receives no more distributions and essentially breaks even on the investment, except for any distributions that he or she may have received to date.
If the price of the referenced stock falls below a certain level (often between 60-75% of the referenced stock’s price when the notes were issued), yields also cease unless and until the price of the referenced stock rebounds to above this so-called “coupon barrier” price. Thus the referenced stock must stay within a “Goldilocks”-style trading range- neither rising nor falling “too much”- for the investor to receive distributions.
It is bad enough that much of the time, investors do not even received the advertised yield because the referenced stock’s price is either too high or too low. But worst of all, and often not fully and fairly disclosed to investors, if the referenced stock falls below a certain level referred to as the “knock-in” price (sometimes for example 50% of the price of the time that the “auto-callable” note is sold) investors then lose a sum of money equal to approximately the entire loss in value of the stock itself. Therefore, if the stock crashes and stays at a low price immediately after purchase, auto-callable notes may result in the loss of the entire principal invested. For example, investors lost nearly all of their investment in a matter of days in connection with certain auto-callable notes linked to Silicon Valley Bank, which collapsed in the spring of 2023.
Taking into account all of these features, the investor is left with an investment with limited return potential and the potential for very high losses- a proposition that few investors would accept if given a balanced presentation concerning these high risk structured products.
“Auto-callable” notes pose several additional risks and drawbacks to investors, including the following:
Illiquidity. Structured notes are primarily designed to be buy-and-hold investments. While some notes have relatively short maturities, measured in months, others might extend out for 10 years or more. “Auto-callable” notes are not listed on an exchange, and there’s no guarantee of a secondary market for trading them, meaning an investor may have no realistic option to sell them at a fair price before maturity.
Pricing. Prior to the issuance of a structured note, the issuer provides an initial estimated value of the note. This value is based on an internal valuation model that prices the embedded components used to structure the note’s payoff. The initial estimated value is generally less than the price of the note, meaning that you’re investing an amount per note that exceeds its estimated value. Many “auto-callable” notes are worth only around 93-95% of the purchase price at the time of purchase.
Credit Risk. Structured notes are unsecured debt obligations of the issuer, meaning that the issuer is obligated to make payments on the notes as promised. If the structured note issuer defaults on these obligations, investors may lose some, or all, of the principal amount they invested in the structured notes as well as any other payments that may be due on the structured notes.
Commissions. These notes oftentimes have embedded commissions of over 2%.
Brokerage firms and financial institutions that have reportedly issued large quantities of at least $1 billion worth of “auto-callable” notes over the past decade include the following:
Institution Issuance
UBS $26.1 billion
Goldman Sachs $22.3 billion
JP Morgan $21.9 billion
Morgan Stanley $20.5 billion
Barclays $17.2 billion
Credit Suisse $11.5 billion
HSBC $10.5 billion
Bank of America $6.7 billion
BMO $5.5 billion
RBC $5.3 billion
Toronto Dominion (TD) $2.8 billion
CIBC $1.5 billion
Brokers are required by FINRA to only recommend investments that suit their investor’s needs. (Read more about FINRA Rule 2111: “The Suitability Rule.”) The fact that these bonds risk losing the entire principal investment makes them unsuitable for many investors. Investors who expressly stated that they wanted conservative investments should not have been placed in these high-risk notes.
Further, for investments after June 2020, brokers and financial advisors have a duty under SEC Regulation BI (84 Fed. Reg. 33318 et seq.), to act in the brokerage customers’ best interest. And must give “advice . . . that is in the best interest of the retail investors and that does not place the interest of the firm or the financial professional ahead of the interests of the retail investor.” Perhaps most notably in the case of “auto-callables” the advisor also has the obligation to consider reasonably available alternatives as part of determining whether recommending a given product to investors is appropriate. One could query whether any “income” investment that has a fixed yield, only payable under limited circumstances, and which poses the risk of the loss of the entire principal invested, is ever a reasonable recommendation when there are so many readily available alternatives without similar drawbacks.
Investors who wish to discuss a possible claim may contact a securities arbitration lawyer at Law Office of Christopher J. Gray, P.C. at (866) 966-9598 or via email at newcases@investorlawyers.net for a no-cost, confidential consultation. The firm has handled numerous cases against financial advisors who allegedly made misleading or unsuitable recommendations of alternative investments, including structured products. Attorneys at the firm are admitted in New York, Wisconsin and various federal courts around the country, and handle cases nationwide (in cooperation with attorneys located in those states if required by applicable rules).
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