FINRA Cautions Advisors Selling Reverse Convertible Notes

The Financial Industry Regulatory Authority (FINRA) is examining brokerage firm sales practices for reverse convertible notes (RCN) and warning advisors of their obligations to investors. RCNs are a type of structured product that are comprised of high-yield, short-term notes of an issuer and a put-option that is linked to the performance of an unrelated asset or index. Maturity dates typically range from three months to one year.

On the maturity date of the RCN, investors receive either the full principal initially invested or a predetermined number of shares of the underlying asset. The high-yielding short-term notes can convert to an underlying stock, depending on the stock’s price movement. It combines the use of a debt instrument that offers investors an above-market returns and a derivative. The put-option provides for either a cash settlement or settlement with shares of the underlying assets if the price falls below a preset price. The shares can be worth less or more depending on performance during that period.

The complexity of this product can mislead investors to accept risks far beyond what they are willing to or should accept. Many investors were unaware that the higher the coupon rate or rate of return exposed them to higher volatility of the equity like and the greater the risks. The comparatively low returns in the market compared to prior years coupled with the broker commission on this speculative product is a powerful incentive to promote these products. In fact, issuers issued 627 reverse convertibles during the first seven weeks of 2010 representing almost double of the number of issues last year.

This sudden increase has led to FINRA to issue a warning to its members about the complex nature of RCN investments and the need to ensure that firms have adequate supervisory procedures to monitor their advisors’ recommendations of this product. As emphasis in the NTM, the FINRA rules makes it a mandatory obligation for its members to recommend investments which are suitable to their client’s investment objectives and risk profiles only after diligently researching their proposed investment to understand the risks and understanding their clients risk profile, financial needs and investment experience.