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By Dustin A. Zacks
ike a movie that refuses to end, Mortgage Electronic Registration Systems, Inc. (MERS) has continued to generate controversy and litigation long after its beginning. This previously obscure mortgage registry tracks the ownership of over half of the nation’s home loans and has become notorious since the housing crisis began.1 Homeowners began the legal assault on MERS by challenging its right to initiate foreclosure proceedings. Now, MERS faces another wave of legal challenges: county clerks and private qui tam actions assert that MERS has cheated county recorders out of millions of dollars in recording fees. This latest chapter in the tortuous chronicles of MERS represents yet another opportunity for homeowners, litigators, and legislators to consider the direction of recording practices nationwide. Before MERS was created, transfers in the ownership of home loans had to be recorded at county registrars, clerks, and recorders’ offices. This process was costly in terms of fees, wasted time, and accuracy. To bypass this process, the nation’s largest lenders and the government sponsored entities created MERS—an electronic registry designed to track transfers in ownership of home loans. MERS is now listed on millions of home loans as either the mortgagee or as the beneficiary on deeds of trust. At the same time, mortgage language lists MERS’ interest as existing solely as nominee for the true or “beneficial” owner of the loan. In practical terms, this means that MERS remains listed as the mortgagee in the public records regardless of whether the underlying interest in the amount owed has been transferred. MERS continues to act as nominee for subsequent owners of the home loan, as long as those transferees are members of MERS, and any such transfers are
tracked in MERS’ private computerized database. The end result is that MERS eliminated the necessity for lenders to create and record assignments of mortages which would have previously been generated upon sale of a home loan. Instead, assignments are only produced when the loan is transferred to a non-MERS member bank or investor, or when an assignment is necessary to initiate foreclosure proceedings. The time and cost savings were partly designed to ease the process of securitizing home loans. Ordinarily, the securitization process would have required several assignments to be produced and recorded. Lenders have now eliminated the resource drain those assignments represented. For its part, MERS generates a fee each time a lender registers a loan on its system, and claims that the cost savings from not having to record each assignment results in savings for homeowners. Yet once the housing collapse began, MERS was forced to confront legal challenges. Homeowner Challenges in Foreclosure Litigation MERS first gained infamy on the national stage when foreclosure numbers exploded during the housing crisis. Many foreclosures were initiated in the name of MERS, resulting in puzzled homeowners and attorneys asking basic questions about the company and mounting legal challenges. Homeowners and their attorneys propounded a wide variety of legal arguments challenging MERS’ right to foreclose. Ultimately, most jurisdictions have recognized MERS’ ability to foreclose on behalf of the beneficial owner of a loan.2 This is presumably due to the varied language used by MERS in mortgages and deeds of trust. In courts of various jurisdictions, MERS has successfully argued that it is either mortgagee, beneficiary, nominee, agent, holder, or even the owner of home loans. Thus, most homeowners’ advocates fighting MERS-initiated foreclosures have played a game of legal “whack-a-mole,” whereby an argument that, say,
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Dustin A. Zacks is a founding member of King, Nieves & Zacks in West Palm Beach, where his practice concentrates on real estate litigation. Volume 32 • Number 1 • January 2013
Electronic copy available at: http://ssrn.com/abstract=2227789
MERS cannot foreclose because it is not a true mortgagee, is disregarded because a court finds that MERS can represent the true owner as an agent. Furthermore, even when homeowners have mounted successful challenges to MERS-intitiated foreclosures, banks and MERS simply changed tactics. After losing some notable cases in 2011, for example, MERS announced that it will cease foreclosing in its own name.3 Henceforth, homeowners facing foreclosure will have to find other ways to challenge MERS-related foreclosures, such as questioning the validity of MERS assignments. These challenges in the midst of foreclosure litigation are not going away. The long delay home foreclosures face in resource-strapped jurisdictions means that MERS may have innumerable foreclosures in its own name still pending in courts around the country. Furthermore, MERS continues to appear on documents, such as assignments, that are routinely submitted as evidence in foreclosure litigation, meaning that MERS will continue to face questions about its role in evicting homeowners. Given that many homeowners and judges are still relatively uninformed about MERS, it behooves litigators to avail themselves of both sides of the legal arguments surrounding MERS in foreclosures. The New Challenge to MERS: County Clerk Lawsuits Just when the controversy regarding MERS largely seemed to recede, county clerks have dragged it back onto the national stage. Now, rather than facing its most important hurdles in foreclosure litigation, it appears that the most imminent legal threat to MERS is the spate of lawsuits filed by county clerks. All across the nation, county clerks and recorders are suing MERS for large sums, sometimes seeking class-action status, to seek money the clerks claim has been wrongfully withheld. At their core, these lawsuits reflect a most basic, even elemental, conflict between MERS and county recorders: on one hand, MERS was created specifically to avoid having to pay clerks’ fees for assignments, and MERS does not believe it is required to record any assignment between MERS members. On the other hand, clerks assert that MERS has effectively usurped
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the public recorders offices and is required to record— and pay for—all the assignments it avoided recording in past years. Each of the arguments against MERS in these clerks’ lawsuits will be examined in turn. Claim One: State Laws Required All Assignments to be Recorded Common to most clerk lawsuits is their assertion that all changes in beneficial ownership of home loans are required to be recorded in the public records.4 This point necessitates some explanation. As briefly mentioned above, MERS was expressly created to avoid recording every single change in ownership. Thus, before the onset of MERS, a sale of a mortgage loan would result in production of an assignment of mortgage that would typically need to be recorded for a fee. In a mortgage listing MERS as the mortgagee (deemed a MERS Originated Mortgage, or a “MOM”), by contrast, MERS will remain listed in the public records no matter how many times the underlying interest in the loan is transferred. Thus, in the case of a mortgagebacked securitization, the fact that the actual owner of the right to enforce the loan might have changed hands several times as part of the process of pooling loans together is irrelevant for recording purposes. In MOM loans, MERS is listed as nominee to the lender and its successors, so MERS continues to act at the behest of whoever the owner might be, and the public records remain unchanged. Clerks and recorders assert that MERS violated state laws that require recording of all such transfers, and that failure to record resulted in a decrease in revenue for their offices. For example, the Dallas County Texas Complaint cites a Texas statute stating that “[t]o release, transfer, assign, or take another action relating to an instrument that is filed, registered, or recorded in the office of the county clerk, a person must file, register, or record another instrument relating to the action in the same manner as the original instrument was required to be filed, registered, or recorded.”5 Similar statutes are cited by other clerks around the nation.6 By failing to record as required by statute, the clerks argue, MERS deprived the clerks of revenue lawfully due. MERS for its part, argues that clerks are not due money for assignments that were rendered superfluous by the creation of the MERS system.7 In plain English, MERS will usually argue that the clerks do not
Volume 32 • Number 1 • January 2013
Electronic copy available at: http://ssrn.com/abstract=2227789
deserve money for assignments unrecorded. As will be explained, infra, courts have not been especially receptive to clerks’ arguments, even in the face of statutory language which appears to mandate recording transfers of interest. Claim Two: MERS Uses Deceptive Language to Avoid Recording Clerks have also alleged that MERS uses deceptive terms in its mortgage documents for the purpose of avoiding recording requirements and fees. This point can take several different angles: in the Dallas County, Texas lawsuit, for example, the clerk argued that MERS falsely described itself as a beneficiary on deeds of trust in order to get the clerk to accept those documents for recording.8 This can result in an asserted cause of action for misrepresentation, whether fraudulent or negligent. The argument that MERS cannot be a mortgagee while simultaneously describing itself as merely a nominee has already been discussed extensively. The clerks who assert this idea largely parrot the arguments of Professor Christopher Peterson, who cites to various anti-MERS decisions holding that MERS is not a traditional mortgagee or beneficiary.9 Peterson and the clerks argue that it is improper for MERS to list itself as a mortgagee because “[i]t causes county recorders that maintain grantor-grantee indexes to list MERS in the chain of title for the land” and “creates a false lead in the true chain of title defeating an essential purpose of recording mortgages and deeds of trust.”10 In the context of foreclosure litigation, such arguments have not fared well in the majority of cases. As I have discussed elsewhere, many courts have ruled that MERS has standing to bring foreclosure actions, regardless of whether it is a true or traditional mortgagee.11 MERS can be deemed an agent, a nominee, or any number of other such statuses giving it standing to bring foreclosure. In clerks’ lawsuits, however, it was not so clear from the outset that this type of attack against MERS would fail. For the time being, the argument has not resonated with courts in the arena of clerks’ lawsuits either, as will be examined, infra. Essentially, this argument is another pathway that clerks travel upon to arrive at the same place as in their initial claim: MERS engaged in wrongful conduct resulting in economic harm to clerks. In a fraudulent or
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negligent misrepresentation through falsely stating it is the mortgagee, MERS undertakes its wrongful conduct by commission. In failure to record claims, its alleged harm is perpetrated through omission. In either case, the wrongs result in fewer recordings and less revenue generated for clerks. Claims Three, Four and Five: Unjust Enrichment, MERS is Evil, and Other Such Arguments As a corollary to the first two claims typically made by clerks in lawsuits against MERS, such lawsuits frequently contain a claim for unjust enrichment.12 These claims are natural extensions of the first two claims above. The core idea remains the same: MERS allegedly diverts money from county clerks in an improper manner by failing to record assignments. Aside from the most common claims and the unjust enrichment theory discussed above, clerks also have attacked MERS on various other grounds. One tactic, taken by the Dallas County Clerk’s lawsuit, is to paint a picture of MERS as a primary cause of the economic bubble and collapse.13 This line of argument asserts that, but for MERS’ easing of the assignment process, securitization of residential mortgages would never have reached the heights achieved during the housing bubble. Thus, such an argument essentially accuses MERS of causing the current economic crisis. Although it is beyond the scope of this Article to assess the extent of the validity of this claim, it is undisputed that MERS’ easing of the assignment process did facilitate the securitization of home mortgage loans. It is not clear that any clerks are attempting to fashion this argument into a legal claim for relief, but it is nonetheless noteworthy for its attempt to produce judicial skepticism towards the MERS system. Another anti-MERS argument produced in the context of these newly burgeoning clerks lawsuits is that MERS has effectively usurped the public function of clerks and has created a private recording system. Florida’s Duval County Clerk propounded this argument in its lawsuit against MERS by including a novel count for a writ of quo warranto, which sought to prevent MERS from acting as a private recording system and to force MERS to record every future transfer in the public records.14 These claims were echoed by the Dallas County Clerk, who claimed that MERS
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“collapsed the public recording system in the U.S.”15 In some respects, it is clear that MERS does seek to replace the need to record certain transactions. Some of the more virulent MERS critics, like Peterson, have previously raised this point. However, as will be seen, infra, the assertion that MERS unlawfully creates a private system, or that MERS produces unfortunate public policy externalities rarely holds weight with courts. Instead, courts generally assume that MERS and its principals’ failure to record assignments does not violate a statutory duty to record. Qui Tam Actions The claims brought forth by county clerks, and the potential recoveries clerks’ lawsuits sought, have also led to a spate of qui tam actions. One private actor in particular, Barrett Bates, filed several lawsuits in different states, suing MERS on the basis of alleged violations of those states’ false claims acts.16 These false claims acts generally prohibit making false statements or recording false documents to avoid an obligation to pay money to the government.17 Here, Bates consistently claimed in many jurisdictions that MERS falsely claimed to be the mortgagee or beneficiary on deeds of trust in order to avoid having to record assignments and therefore pay document recording fees.18 In this respect, his claims were not altogether unique when compared with the claims made by clerks. What is distinct about these qui tam actions is the additional threshold requirements placed on a plaintiff in order to bring a claim. As will be discussed, infra, these additional requirements resulted in dismissal of Bates’ qui tam actions, although these dismissals do not necessarily mean he or other private litigants will stop filing lawsuits against MERS. The Courts' Response Overall, the “revenge” of the clerks has been hampered by most courts’ failure to allow the lawsuits to progress past MERS’ motions to dismiss. First, regarding the primary claim that state laws require assignments to be recorded, most courts have found that their states’ laws do not, in fact, require all assignments to be recorded. This spelled the death knell for lawsuits in Iowa, Texas, Florida, and Arkansas. The Court adjudicating the Plymouth County, Iowa Clerk’s lawsuit, for example, noted that Iowa is a lien theory state, meaning that an assignment of mortgage does not transfer
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title.19 Thus, given that Iowa law does not require assignments to be recorded, the rest of the clerk’s lawsuit failed.20 Other courts, such as the court ruling on the Hot Springs, Arkansas Clerk’s case, have found that although it may be unwise not to record, recording is simply not mandatory under certain states’ laws.21 One singular exception to this trend is the order denying MERS’ motion to dismiss in the Montgomery County, PA lawsuit, which held that the Pennsylvania statute was unambiguously clear in requiring assignments to be recorded.22 Where courts have found a duty to record, they have generally ruled that the duty does not give a cause of action to the county clerk, but rather to property owners. The Christian County, Kentucky Clerk’s lawsuit was felled by this reasoning. The court there held that the legislature did not intend that county clerks be benefited by the requirement to record documents affecting title. Lack of recording fees for the clerk was not the reason the legislature enacted the requirement; rather, the statute was held to be intended to benefit subsequent property owners, creditors, and homeowners.23 Therefore, the clerk could not sue on the basis of such a requirement. Next, courts have usually rejected causes of action based on the allegation that MERS is lying when it states that it is a beneficiary or a mortgagee. The dominant theory behind this failure could be based upon the existing standing jurisprudence discussing MERS’ various statuses in foreclosure litigation. However, what is apparently more persuasive to courts is the fact that, even if MERS did lie and falsely claim it was a mortgagee or beneficiary, clerks would still have to record those documents. The Duval County Clerk’s allegation of untruthful recording failed on this very point: the court held that the recording was merely a ministerial act unaffected by some general duty to ensure the veracity of the public records.24 Similarly, just as in the case of a duty to record assignments, the courts have held that even if MERS did owe a duty to record wholly truthful documents, that duty does not provide a cause of action to clerks.25 Again, no clerk has yet shown that a legislature intended clerks to be benefited by recording statutes or to gain a cause of action stemming from the public’s duty not to record false documents.26
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Finally, as to the general assertions that MERS has resulted in the downfall of public recording or that MERS helped to cause the housing bubble, courts seem relatively unaffected by such inflammatory language. This is unsurprising to those who have inspected the current state of the law in MERS-related foreclosures. I have noted in previous research that courts seem inclined to discount homeowners’ anti-MERS arguments in the face of a borrower’s default. Similarly, in the context of clerks’ lawsuits, courts seem apathetic towards the overall effects MERS has had on public recording in the United States. Simply put, courts have not been persuaded to rule for clerks based upon the fact that MERS may produce some negative externalities. The Duval County Clerk’s lawsuit seems particularly illustrative of this point: the ruling judge seemed to regard the attacks upon MERS’ manner of business as academic, almost gleefully noting that the county’s claims were significantly drawn from Professor Peterson’s research and from one recently overruled anti-MERS decision.27 This is yet another arena of MERS litigation in which the most virulent MERS opponents do not seem to be persuading the majority. Rather, courts seem to view the development of MERS not as a sneaky conspiracy on behalf of the nation’s largest banks, but rather a new development attempting to deal with modern market realities. Qui Tam actions have met a similar fate as clerks’ lawsuits, but for different reasons. The Bates complaints arose from reverse false claims statutes, which entail more standing hurdles than an average clerk’s lawsuit. Not only do qui tam actions require the private actor bringing suit to prove their substantive allegations, but these suits also evince whistleblower threshold issues. To bring such a suit, a private actor like Bates must show that he was responsible for discovering the information leading to the claim or that he had direct and independent knowledge of the information, and that he delivered that information to the state actor prior to bringing suit. Bates has consistently failed to meet all of these prongs.28 Perhaps most notably, Bates admits that he only became aware of MERS in 2009.29 Accordingly, courts have consistently held that he was not an original source of MERS’ alleged
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malfeasance. Furthermore, courts have noted that Bates’ claims mimic—at times nearly identically—claims or assertions put forth in public accounts of anti-MERS arguments.30 To date, Bates has failed in his qui tam quests in several states. Conclusion So of what import is this most recent spate of MERSrelated litigation, given that the vast majority of suits have been dismissed? First, although this Article has taken a relatively skeptical and pessimistic view of these antiMERS lawsuits, banks and their advocates must remain wary of these seemingly unending matters. Just as the tobacco lawsuits were initially met with skepticism and ridicule, one large win was all it took to turn regular routs into an industry-changing victory. Here, one verdict in favor of a clerk in a class-action suit could result in a ruling that MERS must go back and, for example, record innumerable assignments or pay millions of dollars in avoided recording fees. This, in turn, could result in a new appraisal of the viability of MERS’ manner of business. Similarly, one pro-clerk verdict could spur even more lawsuits. This is all the more reason for MERS and its bank co-defendants to treat these lawsuits as life or death situations. Even suits that survive motions to dismiss could give courage to more clerks to file additional suits. Thus, even though MERS has an impressive string of victories in these cases, each defeat, no matter how technical or procedural, has the potential to cost MERS and its member institutions ever more in legal costs and scrutiny. Another observation based upon these recent clerk lawsuits is the unfortunate tendency of state actors to take underwhelming, tardy, or self-serving action when faced with questionable lender conduct. In the context of the robo-signing scandal, legislators and state attorney generals only began investigating faulty lender practices once the popular press had exposed such conduct years after the first robo-signing deposition had become public record. Then, when lenders were forced to pay for their mistakes, some state legislatures diverted funds to plug budgetary holes rather than to assist homeowners. Likewise, when confronted with news of questionable attorney conduct, the government sponsored entities continued to refer cases to firms under investigation for misconduct.
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The analogy to clerks’ lawsuits is clear: MERS began operating and recording mortgages and deeds of trust around the country long before the housing bubble began to grow. For years and years, MERS increased the percentage of loans for which it appeared as mortgagee on the public records. Yet, prior to popular press accounts and academic discussions of MERS, not a single county clerk around the country found it necessary to investigate what this new amorphous company represented. Only when a potential for recovering vast sums of money became evident did clerks begin to become so concerned with the integrity of the public records. If MERS represents the evil clerks’ lawsuits often assert that it does, then those very same clerks bear an obligation to explain to the public why they did not care to investigate MERS five or ten years ago. Given clerks’ utter failure to account for their lack of initiative during the rise of MERS and that they only have fought MERS now that money is potentially recoverable, clerks’ claims of being concerned with the protection of the public ring incredibly hollow. Next, amid this discussion of clerks’ challenges to MERS, one can consider the implications for MERS in the future separate and distinct from such clerks’ lawsuits. As this Article has noted, MERS has been a lightning rod for litigation and criticism since the housing crisis began. Even now, MERS faces unfavorable decisions from time to time in the foreclosure context.31 Just as anti-MERS rhetoric grew after the collapse of the housing market and the increase in numbers of foreclosures and spurred these clerks’ suits, these suits may yet inspire another wave of litigation involving MERS. What form this wave may take, whether in qui tam fashion or otherwise, remains to be seen. Yet what has remained constant since the collapse of the bubble is MERS’ involvement in a significant amount of litigation and controversy. As seen by the emergence of these clerks’ lawsuits, this trend is unlikely to cease in the future. Finally, any discussion of clerks’ MERS lawsuits would be lacking without mentioning one of the great ironies of the mere existence of such suits. Clerks are suing MERS for its failure to record assignments and its failure to utilize public recorders. Yet, county clerks and recorders’ own ineptness is, in large part, the very
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reason for MERS’ existence. Bankers created MERS out of a need to avoid the costly, inefficient, and often error-prone manual recording services given by clerks. Now, clerks essentially are suing banks for the audacity of desiring to avoid such a drag on the market. If clerks had modernized and provided the speed and quality of service needed by the private marketplace, then the private sector would have had no cause to create MERS in the first place. Furthermore, one can reasonably take either side of arguments regarding the legal propriety of MERS’ failure to record every assignment when a transfer in the beneficial ownership of loans takes place. Likewise, one can make persuasive arguments and counterarguments regarding the effects MERS has had on transparency of public records. What is essentially undisputed, however, is that MERS’ failure to record assignments resulted in less work for clerks. Clerks are therefore essentially asking to recoup money for services not performed. After considering their lack of action during the ascendancy of MERS, their showing initiative only once money appeared to be recoverable, and their attempt to recoup money for services not rendered, clerks’ assertions of righteous fury on behalf of an unwitting public, therefore, are simply not very convincing. One quixotic counterargument to this author’s assertion of irony and insincerity noted above was evoked in the Dallas County, Texas Clerk’s lawsuit. The complaint referenced a clerk’s letter to Iowa Attorney General Tom Miller, which rejected MERS’ claims of saving work for clerks by eliminating recording large numbers of assignments.32 The quoted clerk exclaims, “This is help we did not ask for, nor was it help that we needed.” But in the very same protest, the clerk admits that 57% of clerks do not have e-recording accessible to the public.33 Clerks may not have asked for MERS’ help in reducing the number of recorded assignments, but they certainly spurred it by their failure to modernize to meet the needs of the modern marketplace. In a circular piece of logic, the Duval County Clerk claims that it was MERS’ very failure to pay such recording fees which resulted in the lack of modernization.34 This claim is to a certain degree absurd. It appears from the history of MERS that the converse is true: despite lenders paying fees for interim assignments for years, clerks
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still did not produce a majority of jurisdictions that could e-record cheaply and efficiently. This apparently spurred the need to circumvent the system. In other words, failures of the system produced MERS; MERS did not create the failures of the system. While one can certainly argue, as I and others have, that MERS does obscure the information-bearing capacity of the public records, the fact that lenders thought such a creation was so advisable is a reflection on the antiquated procedures of clerks, not on banks’ sinister intent to destroy the public records of the country. As the law stands now, therefore, even MERS’ detractors have to recognize the impressive ascendancy and resiliency of the MERS registry. Despite arousing popular controversy and countless lawsuits, MERS has by and large weathered most of the storm surrounding its manner of business. As this Article has examined, clerks’ lawsuits and qui tam actions appear to be an expensive nuisance to MERS and to its member institutions. Such lawsuits do not, however, appear to be a final dagger for those who wish to see MERS destroyed. On the other hand, just as anti-MERS decisions in foreclosure can have nationwide repercussions, one victory for a clerk or a qui tam litigant could generate significant losses for MERS and its members. As with all MERS-related litigation, the settled legal result has yet to be realized.
7. Order, District of Columbia ex. rel. Barrett Bates, 2010 CA 002993 B (Super. Ct. D.C. May 7, 2012), at 18-20 (noting the many instances in which MERS has touted its cost savings to lenders by eliminating the need to record assignments). 8. Compl. ¶¶ 105-6, in Dallas County, TX v. MERSCorp, Inc., Case No. 3:11-cv-02733-O (N.D. Tex. Oct. 31, 2011). 9. Christopher Peterson, Two Faces: Demystifying the Mortgage Electronic Registration System’s Land Title Theory, 53 William & Mary L. Rev. 111 (2011). 10. Christopher Peterson, Two Faces: Demystifying the Mortgage Electronic Registration System’s Land Title Theory, 53 William & Mary L. Rev. 111, 143-44 (2011). 11. Dustin A. Zacks, Standing in Our Own Sunshine: Reconsidering Transparency, Accuracy, and Accuracy in Foreclosures, 29 Quinnipiac L. Rev. 551 (2011). 12. See e.g. Compl. ¶¶ 60-66, Fuller v. Mortgage Electronic Registration Systems, Inc., 16-2011-CA-008974 (Fla. 4th Cir. Oct. 31, 2011). 13. Compl. ¶ 25, Dallas County, TX v. MERSCorp, Inc., Case No. 3:11-cv-02733-O (N.D. Tex. Oct. 31, 2011). 14. Compl. ¶¶ 22-23, Fuller v. Mortgage Electronic Registration Systems, Inc., 16-2011-CA-008974 (Fla. 4th Cir. Oct. 31, 2011). 15. Compl. ¶ 26, Dallas County, TX v. MERSCorp, Inc., Case No. 3:11-cv-02733-O (N.D. Tex. Oct. 31, 2011). 16. See e.g. District of Columbia ex. rel. Barrett Bates, 2010 CA 002993 B (Super. Ct. D.C.). 17. Order, District of Columbia ex. rel. Barrett Bates, 2010 CA 002993 B at 8 (Super. Ct. D.C. May 7, 2012). 18. Order, District of Columbia ex. rel. Barrett Bates, 2010 CA 002993 B at 3 (Super. Ct. D.C. May 7, 2012)(“Mr. Bates states that he realized that the naming of MERS as mortgagee of record or beneficiary as nominee for the lender allegedly constituted a false statement, and that the recordation of such a document constituted fraud.”). 19. Memorandum Opinion and Order, Plymouth County, Iowa v. MERSCORP Inc., Case No. C 12-4022-MWB at 15-16 (N.D. , Iowa Aug. 21, 2012). 20. Memorandum Opinion and Order, Plymouth County, Iowa v. MERSCORP Inc., Case No. C 12-4022-MWB at 14-15 (N.D. , Iowa Aug. 21, 2012). 21. Order, Mayme Brown v. Mortgage Electronic Registration System, Inc., Case No. 6:11-cv-06070-SOH at 5-6 (W.D. Ark. Sep. 17, 2012). 22. Memorandum and Order, Montgomery County, PA Recorder of Deeds v. MERSCORP Inc., No. 11-cv-6968 (E.D. Pa. Oct. 19, , 2012) at 12-15. 23. Memorandum Opinion and Order, Christian County Clerk v. Mortgage Electronic Registration Systems, Inc., Case No. 5:11CV-00072-M at 8 (W.D. Ky. Feb. 21, 2012). 24. Order, Fuller v. Mortgage Electronic Registration Systems, Inc., 3:11-cv-1153-J-20MCR at 30 (M.D. Fla. June 27, 2012). 25. Order, Mayme Brown v. Mortgage Electronic Registration System, Inc., Case No. 6:11-cv-06070-SOH at 7 (W.D. Ark. Sep. 17, 2012). Banking & Financial Services Policy Report • 23
1. For a more detailed explanation of the development of MERS discussed in the introduction, see Dustin A. Zacks, Standing in Our Own Sunshine:Reconsidering Transparency, Accuracy, and Accuracy in Foreclosures, 29 Quinnipiac L. Rev. 551 (2011). 2. A more elaborate examination of foreclosure-related MERS litigation can be found in Zacks, supra note 1, at 566-584. 3. Dustin A. Zacks, MERS is Dead: Long Live MERS, 44 Conn. L. Rev. CONNtemplations 62 (2012). 4. See e.g. Compl. ¶ 134, Dallas County,TX v. MERSCorp, Inc., Case No. 3:11-cv-02733-O (N.D. Tex. Oct. 31, 2011)(“Defendants violated section 192.007 of Texas Local Government Code by failing to record all releases, transfers, assignments, and other actions relating to the deeds of trust in which they, separately or jointly, identified MERS as the ‘beneficiary,’”). 5. Compl. ¶ 133, Dallas County, TX v. MERSCorp, Inc., Case No. 3:11-cv-02733-O (N.D. Tex Oct. 31, 2011). 6. Order, Mayme Brown v. Mortgage Electronic Registration System, Inc., Case No. 6:11-cv-06070-SOH (W.D. Ark. Sep. 17, 2012), at 3 (noting that the clerk alleged “a duty to record every mortgage transfer.”). Volume 32 • Number 1 • January 2013
26. Again, the one exception to this is the Montgomery County suit, where the court noted that MERS could not cite to any rule limiting clerks’ right to recover fees. Memorandum and Order, Montgomery County, PA Recorder of Deeds v. MERSCORP, Inc., No. 11-cv-6968 at 30 (E.D. Pa. Oct. 19, 2012). 27. Order, Fuller v. Mortgage Electronic Registration Systems, Inc., 3:11-cv-1153-J-20MCR at 3, 31 (U.S. M.D. Fla. June 27, 2012). 28. See e.g. Order Granting Each Def.’s Dismissal Mot. for Lack of Subject Matter Jurisdiction, State of California ex rel Barrett R. Bates v. Mortgage Electronic Registration System, Inc., Case No. 2:10-cv-01429-GDB-CMK at 8 (U.S. E.D. Cal. Mar. 11, 2011) (Plaintiff ’s allegation in his First Amended Complaint ‘are substantially similar to information already in the public domain.’” (internal cite omitted)).
29. Order Granting The Defs.’ Mot. To Dismiss, State of Indiana ex rel Mortgage Electronic Registration System, Inc., Case No. 49D120911-CT-051734 at 30 (Marion Sup. Ct. June 22, 2012). 30. Order Granting Each Def.’s Dismissal Mot. for Lack of Subject Matter Jurisdiction, State of California ex rel Barrett R. Bates v. Mortgage Electronic Registration System, Inc., Case No. 2:10-cv01429-GDB-CMK at 8 (E.D. Cal. Mar. 11, 2011). 31. See e.g. Bain v. Metropolitan Mortgage Group, Inc., Case No. 86206 (Wash. Aug. 16, 2012). 32. Compl. ¶ 95, Dallas County, TX v. MERSCorp, Inc., Case No. 3:11-cv-02733-O (N.D. Tex. Oct. 31, 2011). 33. Compl. ¶ 95, Dallas County, TX v. MERSCorp, Inc., Case No. 3:11-cv-02733-O (N.D. Tex. Oct. 31, 2011). 34. Compl. ¶ 24, Fuller v. Mortgage Electronic Registration Systems, Inc., 16-2011-CA-008974 (Fla. 4th Cir. Oct. 31, 2011).
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Volume 32 • Number 1 • January 2013
Structured Products and their Regulatory Considerations
By Karol C. Sierra-Yanez
he origin of structured products in terms of design and sale dates back to the 1980s, but it wasn’t until later during the 1990s that they became popular amongst institutional investors.1 These were—and still are—highly sophisticated products, which are in many cases only suitable for investors that truly understand their complexities. However, sales of these products, which were once only focused towards sophisticated investors, have been increasingly driven towards traditional retail investors, giving rise to concern amongst the regulatory community. To better put the growth and size of this industry into context, global new issuance reached $400 billion in 2007 and total sales in the U.S. alone reached $54 billion in 2010.2 Both the Securities Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have issued guidance regarding the sale of these products. Structured products are considered complex financial instruments and it is therefore imperative for registered representatives and retail investors alike to understand what these products entail, both in terms of risk and return. It is also felt by some that structured products are simply too complex and opaque for retail investors and registered representatives to understand,3 thus making them suitable only for the institutional investing community. The general purpose of this paper is to provide an explanation regarding the definition of structured products, some fundamental examples of such products, and the regulatory considerations that should be taken both by financial professionals and by the investing public. Overview and Regulatory Background Structured products are not currently defined in the federal securities laws.4 Former Rule 434, under
the Securities Act (Prospectus Delivery Requirements in Firm Commitment Underwritten Offerings of Securities for Cash), defined structured products as “securities whose cash flow characteristics depend upon one or more indices or that have embedded forwards or options or securities where an investor’s investment return and the issuer’s payment obligations are contingent on, or highly sensitive to, changes in the value of underlying assets, indices, interest rates or cash flows.”5 What are Structured Products? Although structured products are not explicitly defined in the Federal securities law, the SEC and FINRA have provided general guidance as to what structured products are and their regulatory considerations. Structured products are derivatives, due to the fact that their value is derived from some underlying asset or reference entity.6 These are securities whose value is derived from—or based on—a single security, a basket of securities, an index, a commodity, a debt issuance and/or foreign currency.7 Structured products are generally registered under the Securities Act of 1933 (“Securities Act”) in order to facilitate their offerings to retail investors.8 There are various types of structured products, usually offered as medium-term or short-term debt instruments, which are linked to an asset class or reference asset, depending on the product. As described by the SEC, structured products usually offer partial or full principal protection, “higher interest payments, or leveraged and/or asymmetrical exposure to the underlying asset class.”9 Structured products in general do not represent direct ownership of any specific security or portfolio of assets, but rather are promises to pay made by the product’s issuer or creator, which in many cases would be an investment bank. In general, they are senior, unsecured debt obligations of an issuer.10 They are financial contracts between a client (the investor) and an issuer (the counterparty, usually an investment bank) that can be designed with a high degree of customization.11
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Karol C. Sierra-Yanez is an attorney and a member of the Massachusetts Bar Association. She is currently working as a Senior Compliance Analyst at Natixis Global Asset Management in Boston, MA. Volume 32 • Number 1 • January 2013
This ability to be highly customized is largely what led to their rise in popularity with large, sophisticated institutional investors whose specific investment needs could not otherwise be met based on the standardized menu of financial products available to them in the marketplace.12 While these products generally offer full or partial principal protection, there is no guarantee that the investor will get his/her money back. Since they are usually offered as debt, the principal can be lost if the issuer goes bankrupt.13 Structured products are not intended to be thought of as a homogenous group of products, as they can vary significantly from product to product, where the detailed “inner workings are invisible to the end investor, who only sees a single, packaged product.”14 Types of Structured Products Structured products can be classified in different ways; FINRA for example, categorizes them in the following manner: 1. Capital/principal guaranteed products: Generally offer full principal protection but without guarantying any income (e.g. 100% principal-protected note).15 2. Yield enhancement products: usually offer high yielding with capped coupons but do not provide principal protection (e.g. reverse convertible).16 3. Participation products: offer high potential returns and may provide downside protection but usually do not pay coupons. Based on a review by the Office of Compliance Inspections and Examinations (“OCIE”), structured products are issued in five general categories, with payouts and risks varying from product to product.17 1. Partial or full principal protected notes. 2. Enhanced income notes, which typically pay a higher coupon and offer capped returns based on the performance of an underlying asset. These products usually have longer maturities and lower yields than others. 3. Performance/market participation notes, linked to a reference asset such as gold and use long-short strategies. 4. Leveraged/enhanced participation notes, which may pay a return two to three times the return of the
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underlying security/index where the return is usually capped but does not offer principal protection. 5. Reverse convertibles, which will be explained below. This is usually one of the most complex products and investors should therefore be aware of the risks. Examples of How Structure Products Work Structured Notes with Principal Protection The term “structured note with principal protection” refers to any structured product that combines a bond with a derivative component—and that offers full or partial return of principal at maturity.18 Structured notes also go by names such as “absolute return”, “minimum return”, “capital guarantee”, etc.19 Structured notes with principal protection typically include the combination of a zero-coupon bond—a debt instrument that pays no periodic interest until the bond matures—with an option or other derivative component whose payoff structure is directly linked to some underlying asset, index or benchmark.20 While this is one basic example of a structured note, it is important to keep in mind that other structured notes may not include principal protection, nor are all the characteristics (periodic interest payments, level of principal protection, etc.) of various structured notes the same as in this example.21 There are various risks associated with structured notes, including early redemption, which can result in a loss of principal; even if the investor were to receive the principal, the principal protection associated with that product may only apply if the note is held to maturity.22 Another risk associated with the embedded principal protection feature is the possibility of a change in the credit-worthiness of the issuer, such as in the case of defunct Lehman Brothers.23 If the issuer providing the note and/or principal protection were to file bankruptcy, the protection may no longer stand. Due to the complexity of these products, FINRA has issued alerts and regulatory notices to increase investors’ awareness of the risks associated with structured notes.24 These products are typically more complex than traditional bonds, making them more difficult for investors to evaluate.25 In addition, there may be costs and fees associated with structured notes with principal protection that may be high and difficult to understand.26
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The above example highlights a key consideration when talking about structured products, which is the concept of counterparty risk. Within structured products, counterparty risk is the risk of losing money because of the financial failure of the bank/issuer that backs the product being purchased. For example, the principal guarantee within a structured note is only as strong as the creditworthiness of the guarantor, which is generally the investment bank that creates and issues the note. In the event the issuer goes bankrupt or incurs financial distress, investors who hold these notes are considered unsecured creditors and might recover little, if anything, of their original investment. This is a prime example of what happened when investors purchased structured notes with principal protection issued by now bankrupt Lehman Brothers Holdings.27 Reverse Convertible Reverse convertible securities are sold under different name variations and some may or may not include the term “structured.”28 These types of securities are also known as “reversible notes” or “reverse exchangeable securities.”29 These are high-yield securities, usually short-term notes of the issuer, that are tied to the performance of an unrelated reference asset—a stock, basket of stocks, index, etc.30 The high-yield aspect represents the increased risk that the investor may or may not receive the full principal at maturity31 and thus the investor is awarded with higher yield to compensate for that greater level of risk. The investor receives less than the initial principal if the value of the underlying security falls below a certain level, often referred as the “knock-in” or “barrier” level.32 By investing in reverse convertibles, the investor does not own - nor gets to participate in the appreciation of the reference asset; rather, depending on the underlying asset, the investor could receive a predetermined number of shares of common stock (or cash equivalent).33 Since the derivative asset is usually in the form of a put option, the investor wants the underlying asset to remain stable or to go up while the issuer wants the price to fall.34 Investors are attracted to this type of investment because of their ability to potentially earn greater returns than would be otherwise available in certain cases when investing in regular bonds. However, by
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investing in reverse convertible securities the investor is giving up any appreciation in the underlying security and, as previously mentioned, the investor is exposed to additional risks. Regulatory Guidance over the Years FINRA has issued several “Notice to Members” in an attempt to educate investors regarding investments in complex products. In 2003, the NASD (now FINRA) issued Notice to Members 03-71, which set parameters for broker-dealers selling non-conventional types of investments.35 The non-conventional investments were investments that did not fall under conventional equity and fixed income definitions but were products such as asset-backed securities, distressed debt, and derivative products.36 Because of the complexity of these products due to their unique features, such as lack of liquidity, transparency regarding costs, and overall risks, the NASD wanted to remind broker-dealer members of their sales practices when it comes to these type of products.37 Due diligence with respect to these products and suitability were amongst the recommended steps that members should take when dealing with investors.38 Early in 2005, the NASD issued Notice to Members 05-26. This notice specifically addressed best practices when reviewing new products, such as complex products.39 Because of the investors’ (and even the broker-dealers themselves) lack of understanding of these products, the NASD wanted to highlight the necessity for establishing procedures when reviewing new complex products.40 This notice emphasized the need to ask the right questions and—once again— determine investors’ suitability.41 Towards the end of 2005, the NASD issued another notice to members providing guidance regarding the sale of structured products.42 Because these products were often offered to investors as debt securities, the NASD decided to address members regarding sales practices.43 NASD Rule 2210 (d), which addresses communications with the public, indicates that all communications “must be based on principles of fair dealing and good faith, must be fair and balanced, and must provide sound basis for evaluating the facts in regard to any particular security or type of security, industry or service…,” further indicating that the information shall not be misleading.44
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The aforementioned notice indicated that: • Promoting structured products without including information regarding the derivative security and presenting it as debt securities would violate Rule 2210 • Disclosures in a prospectus do not compensate for lack of disclosures in marketing pieces used to promote/sell structure products • Credit ratings, if used, must explain that the ratings refer to the creditworthiness of the issuer and not the market risk associated with the structured product itself; information to the contrary will be misleading • It is important to determine the investor’s suitability before opening an account. In order to accomplish this, firms must perform due diligence, which includes reviewing the risks, costs, and terms of the product • In discretionary accounts, it is necessary to have procedures in place so that written approval of the customer is requested before purchasing structured products in this type of account45 In 2009 and 2010, FINRA issued notices to members regarding protected notes and reverse convertibles. These notices were intended to serve as a reminder regarding the sales practice for these types of products.46 FINRA issued Regulatory Notice 12-03 in January, 2012 in order to provide guidance to firms regarding the use of complex products, such as structured products, equity-indexed annuities, leveraged and inverse exchange traded funds, etc. These products are considered complex because they represent an additional risk to retail investors. Regulators were concerned about the ability of registered representatives and their customers to truly understand how these products will perform depending on the market environment and the risks inherent in them. Lack of understanding of these products may lead to inappropriate recommendations and sales.47 It is important that before recommending the purchase or sale of a complex product, firms and their registered representatives have a reasonable basis for determining if the product is suitable for the investor. As it was previously addressed, firms are further reminded that providing risk disclosures in a prospectus supplement does not cure otherwise deficient disclosure in
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sales material, even if such sales material is accompanied or preceded by the prospectus supplement.48 Therefore, FINRA has indicated that firms should have formal written procedures to ensure that their registered representatives do not recommend a complex product to a retail investor before it has been thoroughly vetted.49 Post-review and training procedures for registered representatives should also be included in the procedures.50 Concerns Associated with Structured Products Both FINRA and the SEC have taken companies’ review and training procedures very seriously when it comes to structured products. As mentioned above, several notices to members and regulatory notices have been issued not only to warn investors but also to educate companies. In 2011, FINRA fined Santander Securities $2 million in a settlement for unsuitable recommendations and lack of proper training regarding structured products.51 FINRA found that Santander had no proper procedures in place regarding the offering of complex products such as structured products, and therefore, brokers were offering these products without sufficient guidance regarding suitability.52 Besides the fine, Santander also had to pay more than $7 million to its customers for losses they incurred as the result of investing in reverse convertible securities.53 Some of the unsuitable recommendations included a couple in the 80s, with a moderate risk tolerance seeking long-term growth.54 This couple was given a recommendation to invest in a single reverse convertible position of approximately $100,000, which was most of their account value and liquid net worth.55 The firm failed to provide the customers with offering documents prior to their investment.56 Additionally, when the firm distributed offering documentation, some of the documents contained material inaccuracies regarding the issuer.57 A Morningstar article written by John F. Wasik indicated that in research he conducted related to structured products he discovered that “investors have lost more than $160 billion in structured and complex income investments.”58 This general lack of disclosure, supervision, and suitablability recommendations has affected not only retail investors but also sophisticated investors as well. For example, Thomas Motamed and
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his wife were awarded $2.2 million in an arbitration settlement with UBS.59 Motamed is (and was at the time of the settlement) the chairman and chief executive officer of CNA Financial.60 One famous case involving structured products involved a class action lawsuit brought against UBS and certain directors and officers at Lehman Brothers. The lawsuit by investors alleged that “UBS violated federal securities laws by selling certain Lehman Brothers structured products, despite knowing that Lehman’s ability to meet these obligations was highly questionable due to its worsening financial condition.”61 In this case, the lack of disclosure is one of the main points for the lawsuit, where investors indicated that UBS’s offering documents for principal protection notes were false and misleading because of the lack of explanation regarding the risks and meaning of “principal protection”, which depended directly on the solvency of Lehman Brothers.62 Conclusion Structured products are complex investment vehicles, and due to this complexity combined with the basic lack of understanding, disclosure, and training associated with them, investors have lost significant capital as a result of misguided investments in such products. As a result, regulatory bodies such as the SEC and FINRA have issued several notices to members, as outlined above, as well as investor alert notices. In these notices, FINRA has cautioned investors who are considering esoteric products that promise higher yields and returns than traditional investments. Therefore, it is important for investors to ask questions before investing. For example, FINRA suggested questions such as: • Does the higher return from the investment come with increased risk? • Do I understand how the investment operates? • What are the costs and fees associated with the new investment? • Is the product callable?63 The burden of obtaining information falls not only on the part of investors themselves but most importantly onto those companies constructing, marketing and recommending these types of products. FINRA has heightened the supervisory requirements
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for complex products. Therefore, companies must assess whether their supervisory and compliance procedures are adequate with respect to these types of investments. Suitability and sales practices for these products are also very important. For example, as part of the suitability analysis, firms must conduct reasonable diligence and obtain proper understanding of the strategies that will be used as well as information regarding the likely performance of the product in a wide range of normal and extreme market conditions. When firms analyze investors’ suitability, they should keep in mind the financial sophistication of the investor as part of the customerspecific suitability analysis. Complex products—as a group—are not inherently unsuitable, but firms should ask questions first and have training and understanding related to these products before making any form of recommendation.
1. Finra.org http://www.finra.org/web/groups/industry/@ip/@reg/@ notice/documents/notices/p014997.pdf (Notice to Members 05-59) (last visited October 15, 2012). 2. http://www.sef.hku.hk/~yjtang/SuitabilityChecksAndStructured Products-01Mar2012.pdf (last visited Nov 26th, 2012). 3. http://www.slcg.com/documents/StructuredProductsWorking Paper_-_11_2_06_-_with_Releases.pdf (last visited Nov 26th, 2012). 4. Notice to Members 05-59). Supra. 5. Id. 6. Notice to Members 05-59. Supra. 7. Id. 8. http://www.sec.gov/news/studies/2011/ssp-study.pdf (last visited Nov 13th, 2012). 9. Id. 10. Marketing Derivatives and Structured Products. Structured Products Summary. FINRA Advertising Regulation Conference, Washington, DC –October 25-26, 2012. 11. Notice to Members 05-59. Supra. 12. Id. 13. http://news.morningstar.com/articlenet/article.aspx?id=367646 (last visited Nov 14th, 2012). 14. Marketing Derivatives and Structured Products-Structured Products Summary, Advertising Regulation Conference (Washington, DC, October 25 -26, 2012). 15. Id. 16. Id. 17. http://www.sec.gov/news/studies/2011/ssp-study.pdf (last visited Nov. 18th, 2012) Banking & Financial Services Policy Report • 29
18. http://www.finra.org/web/groups/industry/@ip/@reg/@notice/ documents/notices/p125397.pdf (Regulatory Notice 12-03) (last visited Nov 15th, 2012). 19. http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/ Bonds/P123713 (last visited Nov 15th). 20. http://www.sec.gov/news/studies/2011/ssp-study.pdf (last visited Nov 15th, 2012). 21. http://www.finra.org/web/groups/industry/@ip/@reg/@notice/ documents/notices/p120596.pdf 22. Marketing Derivatives and Structured Products-Structured Products Summary, Advertising Regulation Conference (Washington, DC, October 25 -26, 2012). 23. Id. 24. http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/ Bonds/P123713 (last visited Nov 15th, 2012). 25. Id. 26. Id. 27. http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/ Bonds/P123713 (last visited Nov 15th, 2012). 28. http://www.finra.org/investors/protectyourself/investoralerts/bonds/ p120883 (last visited Nov 16th, 2012). 29. Id. 30. Id. 31. Advertising Regulation Conference (Washington, DC, October 25 -26, 2012). Supra. 32. Id. 33. Id. 34. http://www.finra.org/investors/protectyourself/investoralerts/bonds/ p120883 (last visited Nov 15th, 2012). 35. http://www.finra.org/web/groups/industry/@ip/@reg/@notice/ documents/notices/p003070.pdf (Notice to members 03-71) (last visited Nov 19th, 2012). 36. Id. 37. Id. 38. Id. 39. http://www.finra.org/web/groups/industry/@ip/@reg/@notice/ documents/notices/p013755.pdf (Notice to Members 05-26) (last visited Nov 19th, 2012).
40. Id. 41. Id. 42. Notice to Members 05-59. Supra. 43. Id. 44. h t t p : / / f i n ra . c o m p l i n e t . c o m / e n / d i s p l ay / d i s p l ay _ m a i n . html?rbid=2403&element_id=10648 (last visited Nov 20th, 2012). 45. Notice to Members 05-59. Supra. 46. http://www.finra.org/web/groups/industry/@ip/@reg/@notice/ documents/notices/p120596.pdf (Notice to Members 09-73). See also, http://www.finra.org/web/groups/industry/@ip/@reg/@notice/ documents/notices/p120920.pdf (Notice to Members 10-09) (last visited Nov 20th, 2012). 47. Regulatory Notice 12-03. Supra. 48. Id. 49. Id. 50. Id. 51. http://www.finra.org/newsroom/newsreleases/2011/p123491 (last visited Nov 27th, 2012). 52. Id. 53. Id. 54. Id. 55. Id. 56. http://www.finra.org/web/groups/industry/@ip/@enf/@ad/ documents/industry/p123490.pdf (last visited Nov 28th, 2012). 57. Id. 58. http://news.morningstar.com/articlenet/article.aspx?id=367646 (last visited Nov 28th, 2012). 59. Id. 60. Id. See also, http://www.cna.com/portal/site/cna/menuitem.8a947c a1d2d625c3b892ba97556631a0/?vgnextoid=11712fc233007010 VgnVCM1000005566130aRCRD&vgnextfmt=detail (last visited Nov 28th, 2012). 61. http://www.girardgibbs.com/case/47/lehman-brothers-ubs-classaction-lawsuit/ (last visited Nov 28th, 2012). 62. Id. 63. Advertising Regulation Conference (Washington, DC, October 25 -26, 2012). Supra.
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