According to a Bloomberg News article today entitled, Massachusetts Investigates Sales of Reverse Convertible Notes, the state securities regulator appears to be positioning itself to potentially take action against the brokerage industry on its sales practices related reverse convertible notes.
Reverse convertible notes are very complex structured investments that are rarely suitable for retail investors. To the average investor, they look like corporate bonds issued by large well-known corporations (e.g. Bank of America, John Deere, Apple, etc) that pay above-average yields over a period of three to twelve months. As a result, they are an easy sell to retirees looking for an investment to provide supplemental income.
In reality, however, reverse convertible notes are not corporate bonds and investors are not investing in large corporations. The investments are actually created by investment banks and investors in these products are actually purchasing an option to receive shares of stock in the large company at a depressed price upon maturity.
For example, an individual invests $25,000 into a hypothetical reverse convertible note linked to Bank of America that pays monthly interest of 8% and matures in twelve months. Therefore, during the twelve month period, the investor receives income payments amounting to 8% per month.
The key question is, however, does the investor receive his or her principal investment back at the end of the twelve months as in a corporate bond? The answer is that it depends on whether the price of Bank of America stock dropped below a pre-determined value during the course of the twelve months. If not, then the investor receives his or her principal investment back in full. If so, then the investor does not get his or her principal investment back. Instead, he or she receives shares of Bank of America stock at a depressed price per share.
This is just one example of a myriad of ways these products are structured and the riskiness is not always clear from the amount of interest the investment pays. For example, a reverse convertible paying 15% over three months may be less risky than a note paying 6% over twelve notes. Therefore, it is very difficult for even very experienced options investors to know whether they are getting a good deal.
To make matters worse, reverse convertibles pay above-average commissions and the financial advisors selling the products often do not fully understand what they are selling. They may know the selling points but that is not sufficient, which is why Massachusetts appears to be positioning itself to take action.
Our firm has represented investors who lost money in these investments. If you have suffered losses, feel free to contact us for a free consultation.