Reverse Convertible Notes Can Be Poisonous for Investor Portfolios
The Financial Industry Regulatory Authority (FINRA) has issued a Regulatory Notice concerning structured products called Reverse Convertibles. The notice is cast a “reminder” to member firms that they have certain “sales practice obligations” in selling such products. Investors should pay attention too, however, as the notice is essentially a warning that Reverse Convertibles and other structured products are complex, high-risk and unsuitable for most individual investors. Indeed, FINRA issued an Investor Alert about these products at about the same time.
These products are popular and often recommended by brokers to income-oriented investors as higher-yield alternatives to more conventional income investments. But brokers and brokerage firms are not providing full disclosure of the risks of these products, and are recommending them to investors regardless of their unsuitability. If that were not the case, FINRA would not have issued the Regulatory Notice and Investor Alert.
A Reverse Convertible (also referred to as reverse exchangeable securities, revertible notes, and the like) is a structured product. Structured products are complicated financial instruments. In very general terms, a structured product is an investment whose value is derived from (or based on) the performance of a reference asset, market measure or investment strategy, which may include equity or debt securities, indexes, commodities, interest rates, foreign currencies, and so on, as well as baskets of them.
FINRA points out that a reverse convertible is a structured product with two components: (1) a high-yield, short-term note of the issuer that is linked to the performance of (2) a reference asset, typically a stock, a basket of stocks, an index, or another instrument.
Brokers often assure potential investors that these products are safe way to earn a higher yield. But, as always, the higher yield is linked to a higher risk that the investor may not receive a full return of principal at maturity. This can occur if the reference asset has fallen in value below a certain level, called the “knock-in” or “barrier” level. If that happens, the investor will not receive his principal back at maturity but instead will receive the lower-valued reference asset. If the reference asset goes up, however, the investor usually will not participate in the appreciation. In essence, FINRA says, “the investor in the reverse convertible is selling the issuer a “put” option on the reference asset in exchange for an above-market coupon during the life of the note.” A put option gives the put buyer the right to put-something-back to the put seller – in this case, the reference asset.
Investors who held these so-called “income investments” in 2008 were shocked to learn what they really owned when the stock market crashed. The FINRA Regulatory Notice implies that, given the put option component of reverse convertibles, these investments are not suitable for investors who are not approved for options trading! Needless to say, this information (if it were disclosed) would cause most investors to say “no thanks” to reverse convertibles, and to think about moving their account to a broker who could be trusted to provide appropriate investment advice.
Why would a broker or brokerage firm do something as improper as recommending an investment that contains an imbedded put option to a conservative income investor? They do it because the “commissions often exceed 2%,” according to InvestmentNews, “Reverse convertible notes warrant sales scrutiny,” by Jeff Benjamin, February 28, 2010.
“It’s really no different than rolling the dice,” said J. Boyd Page, senior partner of Page Perry, LLC in Atlanta. Seth Lipner of Deutsch & Lipner in Garden City, New York observed that “Reverse convertible notes are speculative, high-risk investments that are totally inappropriate and unsuitable for most income-oriented investors. Conservative investors who have suffered significant losses in such products may have compelling claims to recover those losses.”
Page Perry, LLC and Deutsch & Lipner are law firms with over 175 years collective experience representing investors in securities-related litigation and arbitration that regularly collaborate on cases. For further information, please contact us.
