Georgia Securities Regulators Initiate Investigation of Reverse Convertible Securities


The Georgia Securities Commissioner has launched an investigation into sales of structured products called reverse convertible notes made by broker-dealer firms to Georgia residents. The brokerage firms under investigation include UBS AG, Morgan Stanley and Ameriprise Financial. The investigations were begun after the Commissioner received complaints from investors who lost money in these purportedly safe investments.

UBS is a big seller of reverse convertibles. Although UBS lists reverse convertibles on its monthly statements under the heading of “Structured Products,” they are not clearly identified as reverse convertible notes. Rather they have names like “Yield Optimization Notes with Contingent Protection Linked to the Common Stock of ‘,” “Bearish Autocallable Optimization Securities with Contingent Protection Linked to ‘,” HSBC Autocallable Optimization Securities-CP Linked to ‘, et cetera.

Reverse convertible notes are often sold to fixed income-oriented investors including retirees and seniors seeking a better yield in this low-interest rate environment. They are attractive because they promise above-market yields, and are pitched as having very little risk because of a feature called “contingent protection,” which is supposed to protect the investors’ principal.

In reality, however, reverse convertible notes are complex, high-risk, options-driven structured products. Despite brokers’ promises of safety, investors have lost their entire principal in these products ? an outcome they did not expect and were not informed about.

Reverse convertibles are linked to a reference asset (usually a stock or a group of stocks), and the issuer’s payment obligations are dependent upon the performance of this linked asset. Unbeknownst to most investors, however, reverse convertible notes contain an imbedded “put” option that is triggered when the market price of the reference asset drops below a pre-determined level. The put option, when triggered, gives the issuer the right, at maturity, to “put” the depressed (and possibly worthless) reference asset to the investor instead of repaying the investors’ principal.

The Financial Industry Regulatory Authority (FINRA), the securities industry’s “self-regulatory organization” announced back in March 2011 that it was conducting “targeted exams” or “sweeps” of certain member brokerage firms regarding their sales of reverse convertibles. Last year, FINRA sent a notice to members (Notice to Members 10-09) reminding brokerage firms of their obligation to ensure that marketing materials for the high-yield securities are “fair and balanced,” according to the article. That notice was apparently sent because the firms had ignored a previous notice issued in 2005 (Notice to Members 05-57).

The Securities and Exchange Commission has also announced that it is investigating whether Wall Street firms that created and sold reverse convertibles failed to disclose the risks to investors before they bought them.

In what may be the worst investment ever, UBS actually sold a reverse convertible note linked to Lehman Brothers stock. Even though these securities were UBS Notes, representing UBS’s indebtedness ? and even though UBS never defaulted on its debt ? when Lehman Brothers filled bankruptcy, the Notes became worthless, and investors lost all their principal.

There are three main reasons why this reverse convertible is one of the worst (if not the worst) investments ever. First, investors thought they were buying a note, and the risk of total loss of their principal was not disclosed to them. While investors were told that their “return” would vary with Lehman’s stock price, they were led to believe that the existence of “contingent protection” would prevent loss of principal. Thus, while their return might vary, their principal would be protected. That turned out not to be correct. Under the “contingency,” the protection disappeared if Lehman’s price fell too much. This was not apparent to investors, and UBS did not explain it.

Second, UBS did not disclose the true nature of this investment. When UBS’s marketing terms like “Yield Optimization,” “Reverse Convertible,” and “Contingent Protection” are stripped away, this UBS proprietary investment product was actually combination of a coupon UBS Note and a series of esoteric option combinations, involving multiple layers of long and short put options.

Third, UBS sold this Lehman-based investment while hiding its own corporate concerns about Lehman’s future and UBS’ own efforts to avoid the risk of a Lehman bankruptcy. UBS’s had a negative fundamental view of Lehman. UBS was concerned about Lehman’s risk-taking exposure that continued to increase, and it regarded Lehman as vulnerable. UBS had a duty to disclose its own negative view of Lehman to investors before selling them the Notes, but it definitely did not.

J. Boyd Page, the senior partner of Page Perry, said: “Investors in these toxic notes are urged to take action if they haven’t already done so. Investors who were sold these Lehman-linked notes in 2007 and 2008 are beginning to reach, or may have already reached, the four year anniversary of the purchase date. Further delay could result in timeliness issues.”

“UBS knew that Lehman was in trouble as far back as October 2007, but they continued to sell Lehman structured products anyway, ignoring the ever-growing risk,” Mr. Page observed, adding: “Not only weren’t they candid with the public, they weren’t candid even with their own brokers. These are highly complex products; they are too complex for ordinary investors and brokers to evaluate.”

“We continue to receive inquiries from investors who acquired these reverse convertibles as a result of misrepresentations of them as a relatively safe note or bond investment,” said J. Boyd Page, a senior partner at Page Perry in Atlanta. “Our legal team continues to investigate and pursue arbitrations on behalf of investors who purchased these terrible products,” he added. The brokers who sold the structured products are not targets of investor claims.

Page Perry is an Atlanta-based law firm with over 125 years collective experience representing institutional and individual investors in reverse convertible and structured product cases all over the country. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 45 occasions.