UBS and other well-known investment firms are currently making the news for marketing Yield Enhancement Strategy (YES) to its clients as “safe” and “conservative .” While YES was marketed as a safe way for investors to enhance their income stream, YES was anything but safe. Brokers that recommended YES strategies to clients without proper due diligence and disclosure, or that recommended the strategy to conservative income oriented clients, likely engaged in broker misconduct, which could make them liable to those clients. Rather than enhance yield, as promised, the strategy actually resulted in large losses.
YES, designed to earn investors more yield during a time when the markets were relatively stable and interests rates low, involved investing in a series of four options for the S&P 500 Index (SPX). This strategy is also known as an “Iron Condor” Options scheme, and involves an options strategy marketed by some brokers as a low-risk way for investors to enhance the yield from an investment portfolio. An Iron Condor strategy consists of selling one call spread and one put spread, each with the same expiration day, on the same underlying asset. Used properly, the iron condor is designed to have a high probability of earning a small profit, provided that the underlying security has low volatility.
While YES wasn’t going to make investors a huge yield if successful, its intent to hedge risk and earn small returns was not without risk. Not only is risk involved, but YES is extremely complicated, making it difficult for most investors to understand. Because of this inherent complexity, it is possible, even likely, that brokers and brokerage firms recommending the strategy failed to adequately disclose the risks involved, resulting in a lack of understanding on the client’s part. A broker has a duty to disclose all risks associated with an investment and firms must implement adequate risk controls and compliance systems to monitor a broker’s recommendation to engage in YES strategies. Failure to do so constitutes a breach of the suitability rules, is negligent, and also a breach of fiduciary duty.
In addition to not disclosing all the risks, it also appears that brokers marketed these strategies to less sophisticated investors, rather than to the most experienced and sophisticated investors these strategies were intended for. Part of a broker’s duty to only recommend suitable investments relies on the customer’s ability, based on their sophistication and experience, to understand the recommendation. It is negligent for a broker or brokerage firm to recommend a complex, high-risk strategy, such as YES, to investors without sufficient experience or sophistication which would allow them to understand the risk/reward paradigm represented by YES. Not only must the recommendation be suitable for the client’s risk tolerance and investment objectives, the recommendation must take into consideration whether the customer can afford the foreseeable losses. Simply because the probability of a loss is low, if the foreseeable loss is more than the customer is willing to risk and lose, the trade can’t be recommended. If the broker does not have a reasonable basis for believing the customer fully understands the recommendation and the risks, the recommendation is not suitable.
Because YES involves a series of options strategies, firms are required to specifically approve clients for options strategies prior to the trading, and to thereafter monitor the trading to make sure it is compatible with the approved parameters. If a firm approves the opening of an option account and strategies that expose the client to unsuitable risk, the firm has violated certain FINRA rules. When a broker recommends unsuitable strategies, the firm and the broker should be held responsible.
The YES strategy relied on the broker’s prediction of market stability. Inherent in that prediction is the knowledge that markets have periods of extreme volatility. In other words, the YES strategy involved timing the market. The YES strategy depends on low market volatility to generate additional income, and a volatile market causes significant risk to investors. As seen in December 2018 and in recent months, the market became more volatile and caused some investors in YES strategies to lose as much as 20%. Had the market remained stable, YES strategies may have worked. However, whether the strategy worked because of fortunate market timing has no bearing on suitability, which can only be determined at the time of the recommendation.
The risks which resulted in significant losses from the YES strategy were foreseeable, and represented the exact risk of the strategy. If a broker failed to properly disclose these inherent risks, such broker should be held responsible for the negligent recommendation. The YES strategy should never have been recommended as relatively safe and conservative income-producing strategy.
Investors suffering losses from YES strategies or similar products may be entitled to recoup those losses through FINRA arbitration. Remedies available to potential victims may include compensatory damages, attorneys’ fees and costs, and punitive damages. Please contact us for more information.