Investment Insights

Jeff Benjamin

Reverse convertible notes warrant sales scrutiny

Complex structured product sees big jump in sales, catches Finra's attention

Feb 28, 2010 @ 12:01 am

By Jeff Benjamin

A general rule of thumb: When an investment product is so complex that a broker can't explain it in a quick “elevator pitch,” pay close attention to issues related to suitability.

After all, the issue isn't just whether investors understand what they are buying, but also whether brokers understand what they are selling.

Enter reverse convertible notes, a wildly popular but highly complex structured product that has already drawn the attention of at least one regulator and may represent a ticking time bomb if the brokerage industry doesn't step up its oversight of how they are being sold.

“Firms marketing and distributing structured products, or any security that has some complexity to it, need to have systems in place to make sure there's not an overconcentration in a client's portfolio,” said Keith Styrcula, president of the Structured Products Association.

Scott Miller Sr., chief investment officer at Blue Bell Private Wealth Management LLC, which has $270 million in assets, agrees.

“Absolutely, positively, it's about education, because the client needs to understand the risks,” he said.

Issued by securities firms and generating commissions that often exceed 2%, reverse convertibles are high-yielding short-term notes that can convert to an underlying stock, depending on the stock's price movement.

Reverse convertibles are clearly not for everyone. But you wouldn't know it by the way that they have been flying off the shelves at brokerage firms.

Sensing that investors may be open to such products in a low-yield environment, issuers have stepped up production of the controversial securities, issuing 627 reverse convertibles during the first seven weeks of 2010, nearly double the number of new issues a year earlier, according to Arete Consulting Ltd. In dollar volume terms, the $1.1 billion worth of reverse convertible sales so far this year is almost three times higher than a year earlier.

The concern that the Financial Industry Regulatory Authority Inc. has started to home in on involves the way the minutiae of reverse convertibles might be oversimplified during the selling process.

In the most basic sense, a reverse convertible is a securitized put option that pays an investor a guaranteed coupon payment regardless of how an underlying stock performs during the duration of the instrument, which averages about six months. At the end of that period, in addition to the coupon automatically earned, the investor also gets back the amount originally paid for the stock as long as the stock price hasn't fallen below a preset “knockout” level.

If that happens, the investor ends up with the coupon payment and the value of the stock at whatever level it happens to be trading.

Oh, and that guaranteed coupon payment, currently averaging around 12%, is based on a stock's most recent option price volatility. A higher coupon yield should signal a greater likelihood of a stock dropping below its knockout level.

In elevator pitch parlance, this one might require a slow ride to the top of the Sears Tower — and back down again.

To be fair, reverse convertibles do have a place in some portfolios.

Because the stock price is protected as long as it doesn't fall below a certain point, and the coupon is locked in, no matter what, the ideal scenario would be a reverse convertible linked to a stock that is likely to remain flat.

A large part of the appeal is that investors think that “there's a good shot of stocks not going down 40% right now,” said Brad Livingston, vice president of Advisors Asset Management Inc.

The pace of sales could — and maybe should — be slowed as a result of a recent action by Finra.

Two weeks ago, Finra issued its first enforcement action involving the sale of reverse convertibles, in which it reminded the brokerage industry of its suitability obligations. Finra fined H&R Block Financial Advisors Inc. $200,000 for inadequate supervision of reverse convertible sales and also ordered the firm to pay $75,000 in restitution to a retired couple who had their portfolio 40% allocated to reverse convertibles.

Though the Finra notice gave no further details about the case, it occurred between 2004 and 2007, or about a year before H&R Block's brokerage business was taken over by Ameriprise Advisor Services Inc.

The representative cited in the Finra enforcement action, Andrew MacGill, was fined $10,000, ordered to disgorge $2,023 in commissions and suspended from working with any Finra-associated firm for 15 days.

Mr. MacGill, who didn't respond to a request for comment, is listed by Finra as working for Ameriprise in Tampa, Fla.

Finra packaged its enforcement action along with an alert to investors that reverse convertibles “often involve terms, features and risk that can be difficult for individual investors and investment professionals alike to evaluate.”

In its notice to members, Finra dusted off a memo from 2005 that suggested that firms selling structured products that have a prominent option component should consider restricting sales to clients who are eligible to trade options.

Making sure investors are ready to buy reverse convertibles is a nice first step, but the industry should also be doing a better job of making sure that brokers are ready to sell them.

Questions, observations, stock tips? E-mail Jeff Benjamin at


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