SPA, Morrison & Foerster analyze Finra's recent releases and action on reverse convertibles

By Emma Trincal

New York, Feb. 23 - In response to the Financial Industry Regulatory Authority's recently issued regulatory notice and investor alert on reverse convertible notes along with its first enforcement action on the topic, the Structured Products Association and New York law firm Morrison & Foerster hosted a conference call on Tuesday in order to shed light on how to interpret this recent regulatory development.

Lloyd Harmetz and Anna Pinedo, lawyers at Morrison & Foerster, as well as Keith Styrcula, chairman of the Structured Products Association, said that the issues raised by Finra in its regulatory notice and investor alert address potentially abusive sales tactics of reverse convertibles and may give brokers some guidance on how to ensure that they sell the notes only to appropriate investors and with adequate disclosure.

The call was also set to comment on Finra's first enforcement action taken on the same day it released the notice and investor alert. The case involved a $200,000 fine levied against H&R Block Financial Advisors, Inc. for inadequate supervision of reverse convertible sales.

Most popular notes

"Reverse convertibles have been the leading type of structured products in terms of popularity, in terms of retail accounts, for the past several years," said Styrcula. "Reverse convertibles are very much in vogue right now."

This is one of the reasons behind Finra's concerns over the ways these popular instruments are being sold, he added.

"Reverse convertibles and their sales practices have been reported in the mainstream press, in some cases unfavorably," said Harmetz, citing a Wall Street Journal article.

The three recently published documents by Finra, including the fining of a broker, "gives us a sense of what types of issues to focus on," he said.

A limited case

Regarding the enforcement action against H&R Block, Harmetz noted that the case focused almost entirely on the issues of suitability and inadequate supervision.

Finra fined and suspended an H&R Block broker for making unsuitable sales of reverse convertibles to a retired couple with a 40% allocation to these types of notes in their portfolio, according to a Finra press release issued last week.

Additionally, the firm was fined $200,000 for failing to establish adequate supervisory systems and procedures for supervising sales of reverse convertibles to retail customers. The firm was ordered to pay $75,000 in restitution to the couple for losses they incurred.

"What they did is very interesting. At issue is suitability. It's a case where the broker over-allocated a position on a retirement account," said Harmetz.

"It's also a very small case: A $200,000 fine for the institution and $75,000 in restitution," he said.

"Finra did not say that it was troubled by the fact that any sales were made to the investors. Rather, they focused on the concentration," said Harmetz.

Finra was also concerned with the brokerage's inability to monitor the retail accounts and to detect over-concentration, said Harmetz, a problem that fits under the category of inappropriate supervision.

Disclosure is fine

The H&R Block enforcement action also revealed that disclosure issues are not among the main preoccupations of the regulator.

"As lawyers, we think a lot about disclosure. What's interesting in the H&R Block's release is that Finra did not focus on any disclosure point. Perhaps, that may be heartening," he said.

Guidance

The takeaway of the releases, the lawyers said, is that Finra wanted to remind brokers that reverse convertibles are complex instruments and that they can potentially confuse retail investors.

Emphasizing the yield without talking about the risk of losing principal, showing investors the annualized coupon without disclosing the actual percentage return based on the short term of the note and presenting the positive aspects of a deal without explaining the risks were some of the main points Finra addressed in its notice, said Harmetz.

"Concentration and suitability were the main issues," said Pinedo. "Finra again is leaving to the broker-dealer the suitability determination."

Investor alert

Harmetz said that analyzing Finra's positions on reverse convertibles should include the reading of the investor alert.

Answering a question about fees, Harmetz said the investor alert told investors that they "should pay attention to fees" and that "they should be aware that fees may not all be explicitly disclosed."

But in its regulatory notice, Finra made no reference to "how we think your fees should be more transparent or lower," he said.

Possible lawsuits

While Finra did not impose strict and new standards on reverse convertibles, Harmetz did not rule out a wave of lawsuits involving the sales of those products, even noting that some of his firm's clients have complained that they "have been burned."

"Finra has used the headline as a good case to publicize some of the issues that have been on their minds," Harmetz said.

"It is possible that we'll see some litigation, perhaps in Federal court, perhaps in arbitration, and perhaps this may affect the market," he added.

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