In recent years, brokerage firms have marketed and sold reverse convertibles to individual investors as a way to earn a higher yield without taking on significantly more risk. Many of them are seniors living on a fixed income. Fewer and fewer retirees have defined benefit pensions to cover their living expenses. In order to make ends meet, they need their investments to generate more yield than is available in traditional safe investments like certificates of deposit and money market funds. Reverse convertibles seem attractive, at first glance, because they have above-market yields. In addition, brokers, who earn above-average commissions on them, often pitch reverse convertibles as safe. Many investors have told us that their broker said that only the amount of their return was subject to risk, and their principal was safe. Unfortunately, that has not been the case for many investors, who have lost their entire investment in these and other structured products.
Reverse convertibles are complex structured products. They are listed on customer account statements with names such as Buffered PLUS, Buffered SuperTrack, ELKS, PLUS, yield optimization notes and autocallable optimization securities. These names in no way suggest the true nature of the investment, nor do they even let the investor know that it is a reverse convertible.
A reverse convertible is issued by an investment bank. It consists of higher-yielding notes linked to a reference asset, typically a stock or a basket of stocks. Importantly, it is an unsecured loan by the investor to the issuer. When a bank customer takes out a significant loan, the bank requires the customer to put up collateral. If the customer defaults, and all else fails, the bank can collect on the collateral. When an investor in a reverse convertible makes a loan to the issuer, however, the investor has no collateral, no security. The issuer’s obligation to pay is unsecured. If the issuer fails, as Lehman Brothers did, the investor, having no collateral, is out of luck. Brokerage firms typically do not explain this risk to investors or the fact that the investment is a derivative.
In addition to the risk of issuer default, the investor bears other significant risks. Investors can lose their entire investment in a reverse convertible. Reverse convertible notes offer what is called “contingent protection.” This means the issuer will return the investor’s principal at maturity if the stock (or other reference asset) does not close below a certain price as of a set date or during period of time. That is a big “if.” Sometimes, the issuer’s obligation to repay the principal amount is conditioned on the stock not trading outside of a certain range either above or below the trigger price. That is an even bigger “if.”
What happens if the trigger price is breached? Here the product takes an even stranger turn. Unbeknownst to most investors, by purchasing the product, they have sold the issuer a derivative called a “put” option. This gives the issuer the right to “put” the reference asset back to the investor at maturity instead of returning the principal in cash if the trigger price is breached. In that event, the reference asset (typically a single stock) will be worth less (maybe much less) than what the investor paid for the reverse convertible. The investor has then suffered a loss of principal, perhaps even the entire principal amount.
Like the risk of issuer default, this embedded put option is typically not well understood by the selling broker, and, therefore, not properly explained to the customer.
Regulators have issued warnings and notices to brokerage firms expressing their concern that the true risks of reverse convertibles are not being explained to investors, and that these structured products are unsuitable for most investors. For example, the Financial Industry Regulatory Authority (FINRA), which is the brokerage industry’s “self regulatory organization,” has warned that reverse convertibles “often involve terms, features and risk that can be difficult for individual investors and investment professionals alike to evaluate,” and that firms that do not limit reverse convertibles to accounts approved for options trading “should be prepared to demonstrate the basis for allowing investors with accounts not approved for options trading to purchase reverse convertibles.”
Options trading is a speculative, high-risk trading strategy. For this reason, and also because of the risk of issuer default in some cases, reverse convertibles are unsuitable for most investors, and should be avoided by those seeking a relatively safe source of income.
If you have investment losses or problems involving reverse convertibles, call the lawyers at Page Perry for experienced representation at (404) 567-4400 or (877) 673-0047 (toll free).