According to Bloomberg, the SEC is investigating to see if investors were defrauded into buying complex bonds known as reverse convertible notes. Reverse convertibles are securities that promise to pay investors a comparatively high fixed rate of interest and repay the investor’s principal , unless a stock to which the product is linked falls below a certain price. If the stock’s price drops below the set price, investors can be paid less than the note’s face value. Thus, the purchaser of a reverse convertible note has to weather the risk of both the note issuer’s credit worthiness and the risk of a decline in the price of the linked stock. As FINRA, which regulates brokerage firms, warned in an Investor Alert entitled “Reverse Convertibles—Complex Investment Vehicles“:
“Although often described as debt instruments, they are far more complex than a traditional bond and involve elements of options trading. Reverse convertibles expose investors not only to risks traditionally associated with bonds and other fixed income products—such as the risk of issuer default and inflation risk—but also to the additional risks of the unrelated assets, which are often stocks.”
Unfortunately, brokers are not doing a good job advising clients of the many “gotchas” of these complicated investments. A particular risk identified by FINRA is that, “typically, the stated yield that is advertised is the maximum return that you could achieve on the product in the best circumstances — not a guaranteed return or even a likely return.”
The SEC and FINRA are reportedly investigating whether the brokerage firms that sold these products adequately disclosed their risks and whether they were sold to clients for whom their risks made them unsuitable. Last year FINRA fined Ferris Baker Watts LLC, (now a part o f Royal Bank of Canada) and H&R Block Financial Advisors (now owned by Ameriprise Financial Services) for improper sales of reverse convertibles. The firms settled without admitting or denying liability. Other firms that peddled reverse convertibles include: JP Morgan, Barclays, Citigroup, Wachovia, Lehman Bros. and ABN Amro.
Reverse convertibles demonstrate once again that when Wall Street claims it has invented a better mouse trap, investors need to remember that they are the mouse.