More complex securities

Direct participation plans (DPPs)

The primary feature of a DPP is the passthrough of losses in addition to gains. Other investments, like REITs, pass through gains but not losses; DPPs pass through gains AND losses. There are several corporate structures DPPs can be, usually a limited partnership, but it could also be an S-corp, or a similar type of structure.

With all limited partnerships, there is at least one general partner. For the general partner to raise money for the DPP, they could do it publicly or privately. To offer the securities publicly they must register with the SEC, and use an underwriter, a sponsor, or a syndicator in the case of DPPs. To offer the securities privately, the general partner would attempt to locate potential buyers, and most often conduct the offering under Regulation D, which would therefore make it exempt from registration.

Risks

DPPs have numerous risks associated with them, are definitely not suitable for most investors due to those risks, and therefore have some key disclosures that must be made. Risks, including the fact that these are not liquid investments, often require the general partner’s permission to sell. Member firms must also verify the suitability, and must have reasonable grounds after reasonable diligence that; The investor is in the financial position to be able to afford the investment, that the client will benefit from the tax benefits of the program, and that they meet all other suitability standards. Member firms must keep records of how they verified the suitability and appropriateness of DPP recommendations.

Suitability

To determine the suitability, the issuer provides a subscription agreement, which would contain similar disclosures as a prospectus, but also is the application itself for the DPP. When someone wants to invest in a DPP, they are choosing to become a partner in the partnership, and makes a capital contribution that establishes their basis in the partnership. The basis is basically the amount they have at risk and can lose in the event the DPP fails. Limited partners are a lot like shareholders of a corporation, in that they have limited liability. The new partner, along with all of the others, have a capital account that represented the contribution that particular partner made to the partnership/DPP. Partners will only be liable for assessments that become part of their capital account, not anyone elses. The capital account of each partner is reviewed and adjusted annually based on the results of operations of the partnership.

For a firm to participate in a DPP offering, the firm must determine that the organization and offering expenses are fair and reasonable. The maximum amount of underwriting compensation is 10% of the gross dollar value of the total of the securities being sold.

Rollups

Rollups regarding DPs are transactions that involve the combination or reorganization of one or more limited partnerships, directly or indirectly. Often several smaller partnerships are merged into a new entity that could be a corporation, REIT, a new partnership, or similar. When soliciting votes for a rollup, the compensation that is paid for soliciting can be no more than 2% of the exchange value of the newly created securities and that it is paid equally regardless of whether partners rejected the proposal or not.

Master limited partnerships (MLPs)

Master limited partnerships are a type of limited partnership that is actually publicly traded on an exchange, and is most often found in energy or resource industries and businesses in them. Most limited and general partnerships do not trade on any exchange, and therefore are illiquid, or at least have extreme liquidity concerns. MLPs combine the tax benefits of limited partnerships with the liquidity of publicly traded securities. The MLP must receive income from some qualifying source in order to qualify for the pass-through tax benefits. Examples of the qualifying sources, again most of these are energy and resource businesses, would include things like exploration, extraction, refining of oil and/or gas, mining, and similar examples. At least 90% of the income the MLP generates must be from these qualified sources, in order to qualify as an MLP and get the benefits. These are complicated and sophisticated securities, and the investor must carefully consider whether the tax complications are worth it.

Structured Products

Structured products are a very complicated product. That would make it seem weird to be in a “basic securities” chapter, but thankfully, we do not need to know a great deal about them. Mostly just the outlines, and some of the suitability aspects. These products are generally most suitable for institutional investors, maybe not all cases, but certainly most.

Structured products are a prepackaged, customizable, debt-based investment that combines a fixed income security and a derivative. It helps create specific risk-return profiles. One of the principal risks in these products, above the individual risks in their creation, is their complexity risk. These things are very complex.

A common example is the principal protected note, a PPN. It is a structured product, which is a fixed income security, combining a zero-coupon bond with an option linked to some other asset, index, or benchmark. The idea being that the investor is guaranteed their investment back, up to the creditworthiness of the issuer, and potential gain from the option as well. If the option was based on say, the S&P500, and the S&P500 went up 25%, they would gain the 25%. There apparently was some interesting news around Lehman Brothers a few years ago, and their PPNs. These are only protected up to the creditworthiness of the issuer.

Exchange-traded notes are one of the more common structured products, even if they are mostly a distraction. ETNs look like ETFs and are often confused, but they are very different. Firstly, ETNs are even more likely to be suitable for institutional investors than other structured products. They are an unsecured senior debt. The return is linked to some index, usually treasury notes, but it could be a commodity, currency, or basically anything. They do trade on exchanges and can be shorted.

Reverse convertible securities are a short-term structured product issued by brokerages and banks. Effectively, the investor will be paid a higher than typical interest rate, but they may be converted to stock to the investor instead of the cash they would expect from a traditional debt. Normal debt securities, at maturity, pay principal in cash. These could pay it in stock if the stock price drops to where it is advantageous for the issuer.