Finra's first reverse convertible fine surprises industry, sources say

By Emma Trincal

New York, Feb. 16 - The Financial Industry Regulatory Authority issued a regulatory notice on reverse convertible notes along with its first enforcement action involving the sales of reverse convertibles, according to the industry watchdog's web site.

While the release of the notice had been expected for months, the announcement in one press release of the fine of a broker for unsuitable sales of reverse convertibles combined with a statement of publication of the regulatory notice took some by surprise, sources said.

"There was nothing surprising in the regulatory notice, except the tone regarding H&R Block. It caught me off guard," said an industry participant.

Finra fined H&R Block Financial Advisors, Inc. $200,000 for inadequate supervision of reverse convertible notes sales, according to the release. It also suspended and fined a broker at that firm for unsuitable sales to a retired couple.

Unexpected combination

According to the release, Andrew MacGill, the fined broker, had recommended that his clients - a retired couple - buy reverse convertibles, which led them to hold 40% of their assets in nine reverse convertibles.

Additionally, the firm was fined for having a deficient surveillance system that failed to flag suitability problems for reverse convertibles transactions, according to the release.

"At first brush, the single [enforcement] situation involves a broker who concentrated 40% of a retiree's portfolio in reverse convertibles. It appears to be more on concentration risk than on reverse convertible risk. That's the first take," Keith Styrcula, chairman of the Structured Products Association, told Prospect News.

"We expected the notice. We've been expecting it for months. We just did not expect that it would be coupled with a fine against a broker," the industry participant said.

"In my view, it's not a coincidence that the notice was issued at the same time as the enforcement action," Styrcula said. "The fine makes the notice strident in its tone. I think it gave Finra the opportunity to dust off a notice to members they've had in draft for the last nine months. This enforcement release gave them an opportunity to come out with the notice."

The enforcement case may also help regulators and brokers engage in a dialogue regarding reverse convertibles, Styrcula noted.

"On this first fine, there may be a legitimate discussion to be had on the role of reverse convertibles in a portfolio. Reverse convertibles provide a certain income for someone who is moderately bullish. There is a place for those products in a portfolio. This enforcement action is about a concentration issue. It's not a statement that reverse convertibles should not be offered to retirees. I don't think it would be unsuitable for a retiree couple to have a modest investment in reverse convertibles. But 40% creates a problem," said Styrcula.

Good sales practices

The notice aims to caution firms about potential sales practice violations when selling reverse convertibles to retail clients.

It comes two months after the release of another Finra notice on principal-protected notes and five years after Finra's first regulatory notice on structured products in 2005.

In its new regulatory notice, Finra said that financial advisers have to explain "how the product works, including its payout structure." In particular, advisers should not suggest that reverse convertibles are ordinary debt securities, Finra said.

The need for disclosure of liquidity risk, credit risk and a clear explanation of the exact coupon amount based on the note's tenor were reiterated.

Finra reminded firms that a sales document is not a substitute for a prospectus.

Suitability issues were underscored in line with requirements contained in Rule 2310.

"[The] SPA is still studying the notice and the press release discussing it with external lawyers to decide what it means," Styrcula said.

Options accounts

The notice reminds investors that when investing in a reverse convertible note, they are selling a put option to the issuer.

As a result, a paragraph called "eligible accounts" at the end of the document suggested, without requiring it, that firms consider selling reverse convertible products only to investors whose accounts have been approved for options trading.

"This part on options is not a big deal," said Styrcula, adding that it is consistent with the 2005 regulatory notice. "I don't think there is a change and besides, they haven't made it mandatory."

Anna Pinedo, a lawyer at Morrison & Foerster, agreed that the options clause is consistent with prior notices, including the 2005 notice.

"But I thought that they had backed off from that view. I was surprised that they reiterated that. I thought that it was a decision for each firm to take," she said.

No big surprises

"People had been waiting for this for a while. Some thought that we wouldn't see the notice from Finra until we learned at a recent conference that it would come out," said Pinedo. "There is nothing very surprising here, nothing really new in terms of what Finra says. They simply went into more details with the chart in explaining how it works."

The notice features a two-page chart describing five potential payout scenarios based on several variations in the price of the underlying stock relative to the knock-in level and the original price.

"These are complex securities, and they can have complex payouts. But they are not all complex. Some have simpler payouts," said Pinedo.

Impact on issuance

Whether the uncertainty around the much-anticipated regulatory notice will now be lifted, boosting issuance to new highs, or whether sales may slow down remains unknown, said Styrcula.

"It's too soon to tell if it will impact issuance. Whatever happens, I don't know. Inevitably, the notice will lead to some internal reviews. Nothing will change with the prospectus. It's about sales practice. It's going to be a case-by-case suitability analysis," said Styrcula.

"To Finra's credit, every time we have an opportunity to have written guidelines on marketing, there is a positive element to that," he added.

In its press release, Finra also announced the issuance of an investor alert called Reverse Convertibles --Complex Investment Vehicles.

In the coming weeks, Finra will be offering formal and informal instruction in reverse convertible notes sales compliance on its website, www.finra.org/education.

Calls to several members of Finra's emerging regulatory issues division were not returned, and a spokesman at Finra did not return a call.

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