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Complex Bond Faces Regulators' Scrutiny

Wall Street Journal

‘Reverse Convertible Notes’ Can Tumble Along with Stock

Securities regulators have broadened their probes into whether Wall Street sold a complex type of bond without fully disclosing the drawbacks to individual investors.

Known as “reverse convertible notes,” the product pays interest but also is tied to the performance on an underlying stock, so if the stock tumbles, investors can lose big chunks of money.

The Securities and Exchange Commission is investigating whether Wall Street firms that developed the bonds failed to adequately disclose the risks and fees to investors before they bought the notes, according to people familiar with the situation. They also are examining the disclosure of potential conflicts of interest, such as a bank selling a note linked to the stock of a company it is advising. Meanwhile, the securities industry’s self-regulatory organization, the Financial Industry Regulatory Authority, is likely to impose by this summer a large fine against a brokerage firm for improperly selling reverse convertible notes, people familiar with the matter said.

The securities firms being targeted by Finra couldn’t be determined, and it isn’t clear if the SEC’s probe will result in civil charges against underwriters or sellers of the notes. But the investigations are the latest sign that regulators are zeroing in on possible wrongdoing by brokerages amid booming sales of complicated derivatives packaged for mom-and-pop investors.

Last year, sales of retail structured products hit a record $52 billion, up 53% from $34 billion in 2009, according to industry database Investors have flocked to reverse convertible notes because they generally offer potentially eye-popping returns over a short time period. Instead, some investors suffered steep losses because the stock to which their bonds were pegged tumbled in value.

The SEC’s investigation is being conducted by a special enforcement unit in charge of structured and new products. A spokesman for the SEC and a spokeswoman for Finra declined to comment.

Securities firms churned out reverse convertible notes as a way for investors to outperform skimpy interest rates. The bonds pay a fixed interest rate and guarantee to return the investor’s initial investment after a specified period, unless the linked stock falls below a certain threshold. If that happens, the notes often pay back just a fraction of the original investment.

Keith Styrcula, chairman of the Structured Products Association, a trade group, defends the product. He said most reverse convertible notes work exactly as intended and are “less risky than common stock in most cases.”

The reverse convertible notes are created by a number of Wall Street banks, and sold by most major brokerage firms. The SEC’s investigation includes reverse convertible notes issued last year by J.P. Morgan Chase & Co. and Barclays PLC, according to people familiar with the matter. SEC officials have asked for information on notes that were tied to the performance of shares in recording-device maker TiVo Inc., these people said.

The total return on the TiVo notes was less than $600 per $1,000 invested. TiVo shares plunged after the company lost a court ruling last May in a long-running patent dispute. A TiVo spokeswoman declined to comment. The company had no involvement in creating the notes, a person familiar with the matter said.

The prospectuses for the notes each contained disclosures on risk factors, but didn’t refer to the pending TiVo court ruling. Craig McCann, founder of Securities Litigation & Consulting Group Inc., a Fairfax, Va., consulting firm that offers expert testimony on behalf of investors and regulators, said the ruling “was almost certain to make the difference between profit and significant losses for the investors.”

J.P. Morgan and Barclays declined to comment. Officials of the two banks have told SEC investigators that the reverse convertible notes were put together at the request of wealthy investors who wanted to bet on the patent dispute, according to the people familiar with the matter.

Dr. McCann calculated that the stock prices in 28% of the 1,255 reverse convertible notes issued by Barclays last year fell below the “trigger level” that can result in losses for investors. About 15% of such deals by J.P. Morgan fell below that level, he said.

“Reverse convertible notes are being sold as if they were just another type of bond, and they’re nothing like a bond,” said Philip Aidikoff, a partner at Beverly Hills, Calif., law firm Aidikoff, Uhl & Bakhtiari who has represented investors in arbitration claims against brokerage firms that sold the notes. “People looking for a higher income are being sold these terribly complex, high-cost products that can land them with a stock that’s going through the floor when they don’t even want to be in equities.”

Others point out that the products have proved profitable for many investors. More than 80% of the reverse convertible notes that paid out last year left investors with a profit, according to a review by, and the average total return was about 4.5%. By comparison, the S&P 500 index-which doesn’t have the notes’ built-in protection against some falls in stock values-produced an overall return last year of about 15%.

“Part of the reason reverse convertibles are so popular now is that many investors are having a positive experience with them,” Mr. Styrcula of the structured products trade group said.

Finra last year fined Ferris Baker Watts LLC, now part of Royal Bank of Canada, and H&R Block Financial Advisors, now owned by Ameriprise Financial Services Inc., for inappropriate sales of reverse convertible notes. The firms didn’t admit or deny wrongdoing.