A Survey of Reverse Convertible Risks as Bank of America Takes Structured Note Sales Title

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As Bank of America flies into the structured note sales lead amongst US investment firms with $3.28 billion of issuance with $3.04 billion (94%) linked to equities, an overview of the risks associated with structured products such as reverse convertibles is in order.

According to the figures, Bank of America was helped to the sales lead by its focus on large deals as opposed to so-called electronic platform-sold customizable securities, which allow banks to create smaller offerings.

Structured notes are created when a bank packages debt with derivatives—contracts whose value derives from stocks, bonds, commodities or currencies—and, because of this association, also carry larger risks.

The basic structure of a "reverse convertible" a/k/a "reverse convertible note", "reverse convertible bond", "revertible", "RevCon", "RCN" or more generally known as a "strucutred product" links a promissory note issued by a borrower, often a financial institution, and a derivative position in an unrelated company. For example a reverse convertible might consist of a promissory note issued by Barclays' Bank and a put option on Apple stock.

The promissory note carries an above-market yield, but the put option contains the risk.

The promissory note is generally linked to a put option on a stock which gives the issuer the right to "put" (or forcefully give) the stock to the investor if the price of the stock drops below a certain limit price during the term of the investment. If the stock is "put" to an investor, the investor must accept the stock in lieu of receiving a return of principal.

In January 2013, the "Revenge of the Reverse Convertible" proved just how dangerous the high risk product can be. Often sold to yield-seeking investors as a "safe" or "secure" bond instrument, reverse convertibles are anything but.

When reverse convertibles linked to Apple stock went on the market in 2012, Apple shares were valued at over $700 per share. By January, they closed at under $450 per share, losing nearly 40% their original value, placing investors in jeopardy of losing up to 40% of their principals.

In other words, the investor enjoys the interest on the promissory note when the stock price remains stable or rises in value while the issuer wins—big—when the stock falls below the limit price and allows the issuer to exercise the put option. Often times, the investors' losses run between 20% to 50% of the invested principal. Comparatively, the yield on the promissory note is often small, and if annualized may only be 5% to 10%.

When Bank of America acquired Merrill Lynch, Pierce, Fenner & Smith, Inc., the firm was accused of overcharging customers by $32 million in excessive fees related to the merger.

FINRA also fined Merrill Lynch $450,000 for having a poor supervisory system related to structured products.

In July 2012, FINRA barred California broker Alfred Chi Chen for unauthorized trading and improperly recommending reverse convertibles to clients whose risk tolerances were low. At the time, FINRA found Chen systematically selected inexperienced, elderly investors and fraudulently changed their risk tolerance to a higher level.

In 2010, Jonathan W. Evans won an arbitration claim against Wells Fargo for the unsuitable sale of reverse convertible securities to a senior citizen. The award, Finra Case No. 09-00339 is available on FINRA's website.

If an advisor or stockbroker sold you reverse convertible securities which resulted in the stock being put to you for a loss or structured products have been improperly recommended or unsuitably sold to you, please call The Law Offices of Jonathan W. Evans & Associates at (800) 699-1881 for an investigation and consultation. As always, each case is individual to its own set of facts and our successful resolution of prior cases is no guarantee your case will be resolved on such favorable terms.