Regulators Widen Probe of Reverse Convertibles – SEC Also Jumps into the Fray


Securities regulators are expanding their investigation Wall Street’s sales of reverse convertibles, according to Jean Eaglesham’s Wall Street Journal article entitled, “Complex Bond Faces Regulators’ Scrutiny. Earlier this week the Financial Industry Regulatory Authority (FINRA) announced it was conducting “sweeps” of certain firms to gather information about their advertising for these structured products.

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. The regulators also are scrutinizing disclosure of potential conflicting interests, such as notes linked to the stock of a company the broker is advising. Meanwhile, rumor has it that at least one brokerage firm will be hit with a big fine for improper sales of reverse convertible notes, according to the article.

FINRA is not disclosing which firms are being targeted. Nor is it known whether the SEC will impose civil charges against underwriters or sellers of reverse convertibles.

Reverse convertibles have been sold to income-oriented investors (often retirees on a fixed income) as short-term bonds or notes that provide an enhanced return. In reality, they are a complex combination of (a) a loan to the issuer and (b) a combination of long and short put options on a reference or “linked” security. The so-called “yield” on these so-called “bonds” or “notes” is really a premium on the put option and interest on the investor’s loan to the issuer.

It is impossible for an ordinary investor to evaluate these products. Unbeknownst to most investors, reverse convertibles put investors’ principal at risk. That is because, if the price of the reference security falls more than a predetermined amount, at maturity, the selling firm can return the possible depressed reference security instead of the investors principal.

Reverse convertibles paid 13 percent on average last year, and FINRA member firms sold U.S. investors $6.76 billion of reverse convertibles last year, according to Bloomberg.

The SEC’s investigation includes reverse convertibles linked to TiVo that were issued by J.P. Morgan Chase and Barclays PLC, which lost approximately 40% of their value, according to the article.

The prospectuses apparently did not disclose a pending TiVo court ruling on a patent dispute. J.P. Morgan and Barclays spokesmen told SEC investigators that the structured products were created at the request of wealthy investors who wanted to bet on the patent dispute, according to the article. If that was true, why not just buy TiVo stock?

Page Perry has over 125 years collective experience representing institutional and individual investors in securities-related litigation and arbitration 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 40 occasions.