stock certificateStockbrokers that engage in the sale of reverse convertible securities often like to hype the yield associated with these securities but fail to disclose that when the price of the securities to which the reverse convertible note is linked, increase in value the investor’s return is limited to the stated coupon on the note. However, when the price of the security to which the note is linked, decreases in value, and investors can lose their entire investment. Accordingly, investors’ upside potential is limited, but they bear 100% of the downside risk.

In February 2010, FINRA issued Notice to Members 10-09, and subsequently issued an Investor Alert with respect to the sale of Reverse Convertible Notes.

According to FINRA: Reverse exchangeable securities, commonly called “reverse convertibles,” are popular structured products with retail investors, due in large part to the high yields they offer. However, reverse convertibles are complex investments that often involve terms, features and risks that can be difficult for retail investors and registered representatives to evaluate. Firms are also reminded to ensure that their registered representatives understand the risks, terms and costs associated with these products, and that they perform an adequate suitability analysis before recommending them to any customer.

finra imageFINRA issued Notice to Members 10-09; See also, Staff Summary Report on Issues Identified in Examinations of Certain Structured Securities Products Sold to Retail Investors, U.S. Securities & Exchange Commission (July 27, 2011)(“Some reverse convertible notes are he equivalent to the investor writing/selling a put option on the underlying equity. Such notes lend themselves to being improperly marketed as conservative fixed income investments when in fact they may be very susceptible to volatile or falling equity prices and may carry considerable risk of loss”).

With respect to Reverse Convertible securities, FINRA has also cautioned its members that:

“Firms that do not limit reverse convertibles to accounts approved for options trading should develop other comparable procedures designed to ensure that reverse convertibles are only sold to persons for whom the risk of such products is appropriate.

These firms should be prepared to demonstrate the basis for allowing investors with accounts not approved for trading options to purchase reverse convertibles.”

Gavel on moneyFirms must have adequate written supervisory procedures and supervisory controls that are reasonably designed to ensure that sales of reverse convertibles comply with the federal securities laws and FINRA rules and must also adequately train employees who sell, or who supervise those who sell, reverse convertibles.

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