Finra fines firm for oversight failure, issues reminder of reverse convertible sales requirements

By Angela McDaniels

Tacoma, Wash., Feb. 16 - The Financial Industry Regulatory Authority announced its first enforcement action involving the sales of reverse convertible notes and issued a notice reminding firms of the sales practice obligations they have when selling the securities.

The authority fined H&R Block Financial Advisors, Inc. (now known as Ameriprise Advisor Services, Inc.) $200,000 for failing to establish adequate supervisory systems and procedures for supervising sales of reverse convertibles to retail customers.

"Reverse convertible notes are complex investments which, like many structured products, often entail significant risk of loss," Finra chairman and chief executive officer Richard Ketchum said in a news release. "They are among the most popular structured products with retail investors, primarily because of the high yields they offer. But they also involve terms, features and risks that can be difficult for the retail investors who are buying them and the brokers who are selling them to evaluate.

"Firms selling reverse convertibles or similar structured products must ensure that their brokers understand the risks and costs associated with these products and perform adequate suitability analyses before recommending them to any customer. Firms must also have procedures in place to monitor customer accounts for potentially unsuitable concentration levels of these products."

Finra also released an investor alert to educate retail investors about how these products work.

"For their part, investors should be prepared to ask their brokers the right kinds of questions about the risks, features and fees to determine whether reverse convertibles are right for them - and if they are, how much of their portfolio should be invested in reverse convertibles," Ketchum said.

H&R Block fine

In the enforcement matter, Finra found that H&R Block sold reverse convertibles from January 2004 through December 2007 without a system to effectively monitor customer accounts for potential over-concentration and, as a result, failed to detect and respond to indications of potential over-concentration in reverse convertibles in numerous customer accounts.

Finra said H&R Block used an automated surveillance system when determining the suitability of securities transactions that would flag for review any transaction or account meeting certain parameters relating to, for example, account turnover and concentration levels in a particular security or class of security.

This system, however, was not configured to monitor reverse convertible transactions or reverse convertible positions in customer accounts, and the firm did not establish an effective alternative means to do so, according to the authority.

Finra also found that H&R Block failed to provide enough guidance to its supervising managers on how to assess suitability in connection with their brokers' recommendation of reverse convertibles.

Communications with the public

In its regulatory notice, Finra said registered representatives must ensure that customers make informed decisions about whether to purchase reverse convertibles.

Matters to be discussed should include:

• How the product works, including its payout structure, relevant information about the underlying asset and, if applicable, that the investor will not participate in any appreciation in the value of the underlying asset;

• The fact that the principal value of the investment is not guaranteed and the customer might suffer a loss on the investment;

• That the ability of an investor to sell the product prior to maturity, and the potential sales price, may depend on the willingness of the issuer or another party to maintain a secondary market; and

• If applicable, the fact that the firm has published its own research reports about the underlying asset, the content of that research and how the research is or is not relevant to a recommendation to purchase or sell the reverse convertible.

Under NASD Rule 2210, firms must ensure that all communications with the public are based on principles of fair dealing and good faith, fair and balanced and provide a sound basis for evaluating the facts about any particular security or type of security, industry or service, Finra noted.

Firms may not omit any material fact or qualification if that omission, in the light of the context of the material presented, would cause the communications to be misleading. As an example, Finra said communications should disclose the product and liquidity information noted above to the extent reasonably necessary to balance any discussion of the benefits and advantages of a reverse convertible.

In addition, no firm may make any false, exaggerated, unwarranted or misleading statement or claim in any communication with the public or publish, circulate or distribute any public communication that it knows or has reason to know contains any untrue statement of a material fact or is otherwise false or misleading.

Finra noted that providing risk disclosure in a prospectus or supplement does not cure otherwise deficient disclosure in sales materials.

Firms and their registered representatives should not suggest that reverse convertibles are ordinary debt securities, may not exaggerate the probability that the investor will receive a full return of principal and must not present annualized yield or coupon information in a misleading manner, according to the notice.

Finally, if a firm refers to the product's credit rating, they may not suggest that the rating has any bearing on the expected performance of the reference asset.

Investor suitability

NASD Rule 2310 requires that, before recommending the purchase or sale of a security, firms must have a reasonable basis for determining that the product is both suitable for at least some investors and suitable for each specific customer to whom it is recommended.

The Finra notice said firms must carefully review and understand the risks, costs and conditions of the product as well as its terms and features, including its payout structure, call features, the conditions under which the investor would and would not receive a full return of principal, the volatility of the underlying asset and the product's credit, market and other risks.

Firms must perform this analysis for each reverse convertible they recommend.

To assess the suitability of an investment for a specific customer, Rule 2310 requires that firms make reasonable efforts to obtain information about the customer's financial status, tax status and investment objectives and such other information used or considered to be reasonable in making recommendations to the customer.

Finra said the firm's consideration of the benefits of the product to a particular customer must take into account the potential volatility of the reference asset, the risk that the investor may receive less than the value of the principal upon maturity and the other risks and costs associated with the product.

Firms should also consider the equity position that would result should the customer receive shares in the reference asset instead of a return of principal, and whether that position would be suitable for the customer.

In addition, NASD IM-2310-2(e) emphasizes the obligation of firms to deal fairly with customers when making recommendations or accepting orders for new financial products.

Eligible accounts

Given the put option component of reverse convertibles, firms should also consider whether purchases of reverse convertibles should be restricted to investors whose accounts have been approved for options trading, the notice said.

Finra recommended that firms also consider whether it would be appropriate to apply the suitability requirements for optiond trading to those products, including the requirement for firms recommending opening transactions in option contracts to have reasonable grounds for believing that the customer has such knowledge and experience in financial matters that he may reasonably be expected to be capable of evaluating these risks.

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, in the authority's view.

Finra warned that these firms should be prepared to demonstrate the basis for allowing investors with accounts not approved for trading options to purchase reverse convertibles.

The authority also said that approving an account to trade reverse convertibles is not a substitute for a thorough suitability analysis.

Supervision, training

Finra said firms must adequately train employees and 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.

According to the notice, training for employees who sell, or who supervise those who sell, reverse convertibles should emphasize the need to understand and consider:

• The costs and risks associated with the product;

• The terms and conditions of the product, including the payout structure at maturity;

• The reference stock, index or other asset;

• The investment's potential for growth;

• The product's liquidity before maturity; and

• Any other features that might impact the product's suitability, both generally and for a specific customer.

General questions about the notice can be directed to Laura Gansler (202 728-8275), associate vice president of emerging regulatory issues, or Donald Lopezi (202 728-8132), director of examination programs.

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