The Securities and Exchange Commission told five big Wall Street banks last year to improve disclosures about structured notes that are mostly sold to retail investors, and criticized use of the term "principal protected" in marketing materials.
The SEC sent letters to JPMorgan Chase & Co , Bank of America Corp , Citigroup Inc , Goldman Sachs Group Inc and Morgan Stanley on April 12, 2012, with 14 comments about their marketing, pricing and distribution practices for structured notes that the banks issued from April 2009 through March 2012.
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SEC staff said that using the term "principal protected" for structured notes should also come with disclosures about risk.
The correspondence between the banks and the SEC were released this week.
Structured notes are unsecured bonds that are paired with derivatives, which guarantee the return of an initial investment, as well as some portion of any profits that come from the derivatives trade. However, the investments are not entirely risk-free: repayment of the bond is based on the credit-worthiness of the note issuer.
For instance, when Lehman Brothers filed for bankruptcy, holders of its "100 percent principal-protected notes" were treated like other unsecured creditors. UBS AG , which sold those notes to its brokerage clients, lost a series of related arbitration cases before the Financial Industry Regulatory Authority.
"Note titles using the term 'principal protected' should also include balanced information about limitations to the principal protection feature," the SEC said, adding that issuers should "clearly describe the product in a balanced manner and avoid titles that stress positive features without also identifying limiting or negative features."
In responses to the SEC, all five banks said they do not currently use the term "principal protected" and will continue to review titles of structured notes to ensure they reflect risks as well as positive attributes.
The SEC also pressed the banks to disclose more information about the pricing of structured notes, saying that some issuers inflate prices above fair value for a limited period of time after an offering, and then change those values later. The agency also said that issuers offer "better" prices to certain investors, and asked the banks to disclose more about their pricing and distribution.
Banks said they offer discounts for investors who buy the notes in large quantities, but that otherwise prices are set according to market demand.
Structured notes can be a meaningful source of funding for banks.
As of December 31, 2011, JPMorgan had $35 billion worth of structured notes outstanding, representing 13.5 percent of its long-term funding; Bank of America had $38.6 billion worth of structured notes outstanding at December 31, 2011, representing 10.4 percent of long-term funding; Citigroup had $26.3 billion worth of structured notes outstanding as of March 31, 2012, roughly 8.4 percent of its total long-term debt.
Goldman Sachs had $21 billion worth of structured notes at December 31, 2011, representing 9.4 percent of its unsecured funding. The SEC granted Morgan Stanley's request to keep its structured note issuance data confidential.
(Reporting By Lauren Tara LaCapra; Editing by Bernard Orr)