by Robert G. Yetman, Jr.
A recent arbitration claim filed against Morgan Stanley by an elderly North Carolina couple once again highlights the dangers…to all involved…associated with a firm green-lighting unsophisticated customer investments that are characterized by lopsided portfolio weightings into a complex and risky securities.
According to a piece over at Investment News by Christine Idzelis, now working at IN after spending years cranking out great stuff on credit markets over at Bloomberg News, the unidentified couple is pursuing Morgan Stanley over losses in excess of $100,000 that resulted when the exchange-traded note, or ETN, into which about $150,000 of their total $212,000 portfolio was invested, came crashing down around them. The note is essentially a collateral product of the energy industry, and tracks an index of master limited partnerships that largely own oil and gas transportation and storage assets. To make matters worse, the ETN is a proprietary Morgan Stanley product, which is the sort of fact with which lawyers usually have a field day in cases like this.
What are Exchange-Traded Notes, Anyway?
ETNs fairly fall into the category of “clever” securities. They were devised with the idea of combining, ideally, the best features of bonds and exchange-traded funds (ETFs). ETNs are technically debt securities, but the market feature means they can be traded, sold short, etc. They are unsecured debt obligations issued with the backing of the relevant financial institution (Morgan Stanley, in this case), which means that while a promise to pay exists, there is no guarantee of payment. A key element of ETNs is that the credit rating of the issuer is a function of their stability, so credit risk is a constant companion of the ETN investor, even as the instrument is “exchange-traded.” It should be noted, however, that credit risk did not prove to be the source of the plaintiffs’ problems with the ETN in this case, but, rather, the deterioration of the market with which the security is intrinsically associated (more about that shortly).
The ETN investor can potentially profit in one of two ways: One way is that he can elect to treat the investment as more bond than stock, and hold it to maturity, at which point he receives back his principal investment plus the gain represented by the commodity or asset to which the note is tied. For example, an investor who puts $5,000 in an ETN associated with an index or single reference asset that sees that index/asset go up 10% while he holds it to term would receive $5500 at maturity.
The other way the investor can potentially profit is by deciding, alternatively, to treat the ETN as more stock than bond, and sell it as the exchange-based security it also is, sometime before the maturity date; for example, if the person who invested $5,000 gets two months in and sees that the value of the associated index/asset has appreciated 15% in that brief period, and wants to lock in his profits, he can sell, and pocket $750 on top of his $5,000 principal investment.
Of course, the index or asset can go down, as well, which is what happened here. If such is the case when the note reaches maturity or is sold, the principal investment is reduced by the amount of the index/asset’s loss.
It is worth emphasizing that interest does not accrue on behalf of an ETN, nor is there any guarantee associated with the security – it pays principal, plus or minus what the gain/loss is in the associated index or asset when you cash out (whether at maturity or beforehand).
Troubling Components to This Case
Although there appear to be several issues at play here, surely one of the biggest is that roughly 70 percent of the customers’ total account value was invested not just in one type of more complex kind of security (that can be fraught with liquidity issues), but, further, in one, specific issue of that security; even as relatively harmless as we all typically view broad-based mutual funds, who among us would think apportioning almost three-quarters of a $200,000-plus portfolio into one of those is an example of sound investment thinking?
Some might wonder why liquidity is so much of a concern with ETNs; after all, are they not exchange-traded? The answer is that while, yes, they are…the fact is that “exchange-traded” can be a little deceiving in the case of more exotic securities. Many such securities, ETNs included, are thinly-traded, so while the transactional exchange exists, it does not mean that a genuine market, for all intents and purposes, develops.
An additional problem here has to do with the likely level of investor sophistication that characterizes this couple. It is said that one should not invest in a security that he does not understand, and it would be surprising to me if the plaintiffs…neither of whom appear, based on the rough profiles contained in the article, to be sophisticated investors…even remotely understood what the Morgan Stanley Cushing MLP High Income Index ETN was all about.
The particular ETN at issue here tracks the performance of the Cushing MLP High Income Index, which itself tracks the performance of 30 master limited partnerships that hold assets related to the energy industry (note that master limited partnerships, unlike their “regular” counterparts, are traded on an exchange). For example, two of the index’s constituents, at this writing, are Plains All American Pipeline, LP, and Enbridge Energy Partners, LP. Plains owns terminal, storage, and pipeline assets, and Enbridge also owns assets related to the transportation of oil and natural gas. Theoretically, investments built around the ownership of these kinds of assets are havens within the energy sector, which means that even as things are going south with the commodity itself, an investor might find some relief here, because the energy industry would still need operational infrastructure even as prices tank. That however, seems a largely self-serving assessment; it is awfully risky business to suggest that a commodity-associated industry will reliably thrive, or even manage to tread water, in the face of a price collapse of the commodity to which it is directly and entirely tied.
Moreover, did the investors really understand how the ETN mechanism works, particularly vis-à-vis the index to which it is married? Did they really understand that the security represented ownership of nothing (unlike an ETF), and that the best they were getting was an unguaranteed promise to pay?
To be fair, we can assume that the Investment News article, as is the case with most articles on new and pending arbitration and litigation, does not provide the full context and details pertaining to this situation, largely because such information does not typically come available this early in a proceeding. Moreover, anyone who has spent much time on the registered side of the investment business will tell you that there are those clients to whom you introduce a product and provide all of the relevant disclosure materials, who will then insist that you take a bunch of their cash and dump it in the security, simultaneously choosing to compartmentalize the array of risks inherent with the security type, market, and elected lack of diversification. Still, though, this is where the broker has to stick to his guns and, if that somehow fails, where the firm’s back office can make things right. On that note, I have to wonder where Morgan Stanley’s back office was in all of this. Did a branch manager approve this trade? What about the compliance officer(s)?
According to the Investment News article, the law firm representing the plaintiffs has said that the couple “did not understand the extent that they could lose their principal.” We do not know, at this point, how true that is, but the basic information we have about this transaction…the nature of the security, the portfolio percentage allocated into it, the profile of the customers…seems to strengthen the credibility of such a declaration. Beyond that, if it turns out that Morgan Stanley had discretionary trading authority over the account, something typically granted by clients to firms through a limited power of attorney, then it may well turn out that the trade was made on behalf of the customers without consultation or foreknowledge; if that is true, then it would most certainly prove to be a case that Morgan Stanley loses, given the choice of security as well as the percentage of the account invested into it. Still, even if that is not how this trade went down, the bottom line is that if 70% of an elderly customers’ account really went into a risky, complex, proprietary security, and no red flag went up anywhere before the investment lost over 65% of its principal value, that’s a bad look for the brokerage, regardless of from what angle you’re examining the picture.