Reverse Convertible Bonds

Reverse convertible bonds are dangerously complex and highly speculative investments. That’s how they got the nickname “Nest Egg Slashers,” a term first coined in the Wall Street Journal. Other aliases include “reversible notes” and “reverse exchangeable securities.”

It’s usually inexperienced and conservative investors who fall prey to these widely misunderstood investments. But even experienced investors get confused when it comes to knowing the risks they’re getting into with reverse convertible bonds.

State and Federal laws prohibit stockbrokers and brokerage firms from recommending unsuitable investments to investors who don’t understand the risks involved. If your broker told you to buy reverse convertible bonds, and you lost money because of it, you may be entitled to full or partial compensation for your loss.

How Reverse Convertible Bonds Happens

Prior to the stock market downturn of 2008 and 2009, reverse convertible note sales increased markedly and nearly doubled in 2006 and 2007. News reports have suggested that the reason for the increase in sales was because some brokerage firms were targeting senior citizens and another conservative, risk-averse investors in their efforts to sell reverse convertible bonds.

Because reverse convertible bonds have the word “bond” in their name, many investors get confused and believe them to be ‘safe.’ This makes it exceedingly easy for a stockbroker to misrepresents or omit important information about reverse convertible bonds, and take advantage of an unsuspecting investor.

Most seniors are told reverse convertible bonds are a safe way to generate income for retirement. However, to say that reverse convertible bonds are “safe” couldn’t be further from the truth.

Bringing Reverse Convertible Bonds into Perspective

Reverse convertible bonds are typically tied to the performance of an ‘underlying’ stock or basket of stocks. Therefore, they don’t provide any kind of safety or protection from stock market volatility. In fact, a reverse convertible note is always at risk of getting ‘converted’ into its devalued, and underlying stocks.

Here’s why reverse convertibles are risky:

  • You could lose all your money if the backing financial institution goes bankrupt: When you buy a reverse convertible bond you’re investing into a ‘designer’ or ‘cocktail’ investment product that’s supposed to generate a profit and income for you. However, the investment is backed financially by a bank. Therefore, you’re not only subjecting yourself to the risks associated with the investment, but you’re also taking a risk on the bank. If the bank goes bankrupt, you could lose some or all of your investment immediately. Most investors don’t know about this additional risk and it’s rarely explained to them by the brokers who sell them. Omitting information like this is against the law.
  • Reverse convertible bonds could turn into devalued stock at any time: “Reversible” are linked to the performance of a stock, a basket of different stocks, or some other kind of investment and they pay higher yields than the average fixed income investment. Once the bonds mature, the investor is supposed to get his or her full principal back. However, if the value of the underlying basket of stocks or other investments falls below a specific level, called the ”knock-in” level, then the shares get converted into shares of the underlying securities, which the investor receives in lieu of his or her initial investment. Suddenly, the investor is no longer going to get his original cash investment back on maturity day. Instead, he’s stuck with a bunch of stock shares worth a lot less than his initial investment. This “convertible” aspect of reverse convertibles is rarely adequately explained to investors, and they don’t often know that their investment is more of a stock than a bond. Most reversible investors don’t know their “bond” could turn into a pile of worthless stocks without any notice. When a stockbroker doesn’t explain this, it’s fraud by misrepresentation and omission.
  • The potential for liquidity problems: Trading reverse convertibles on the secondary market have the potential for being a problem – there just isn’t going to be a big market for them. What that means is if you want to sell your reverse convertibles to get access to your money, you could have a hard time doing so.
  • Reverse convertibles pay high commissions to the stockbrokers who sell them and have large fees associated with them: After learning the risks involved with reverse convertible bonds you might wonder why any stockbroker would ever recommend one to a conservative investor. The reason is that they pay a very big commission to the brokers who sell them. In many cases, stockbrokers ignore the welfare of their customers in order to earn big commissions by selling these products. That’s fraud by breach of fiduciary duty.

Discovering Reverse Convertible Bonds Fraud

As referenced above, in 2006 and 2007, countless retirees were sold reverse convertible bonds after being told they’re a safe way to generate a reliable income. However, because reverse convertibles are always in danger of turning into devalued stock, the risk of losing big is extremely real.

When the stock market began to collapse in 2008 and 2009, stock prices plummeted across the board causing many reverse convertible notes to ‘convert’ into the underlying and devalued stocks without warning. Reverse convertible investors suffered massive financial losses in 2008 and 2009.

Unfortunately, most investors don’t discover the true risks associated with a reverse convertible bond until the underlying securities decline to point of hitting the “lock-in” level when to their total surprise they become the owners of a bunch of worthless stock shares.

The Financial Industry Regulatory Authority issued a stern warning about Reverse Convertible Notes. Here’s what FINRA says:

The bottom line is that reverse convertibles come not only with the risks that fixed income products ordinarily carry—such as the risk of issuer default and inflation risk—but also with any additional risks of the underlying assets.

Be Careful and Fight Back

There are a couple great things you can do to make sure you don’t become a victim of reverse convertible note fraud:

  • Ask questions: Ask your stockbroker for a detailed explanation of every investment inside your portfolio and make sure you ask about risks. Ask to follow up questions until you’re certain that you know about any hidden surprises that might be lurking under the surface of a seemingly safe and secure investment.
  • Look for reverse convertible bonds (notes): Read your monthly statements carefully and take note of any unusual investments. It’s possible that your stockbroker convinced you to buy reversible by telling you they were “bonds”. You may have invested in reverse convertibles without knowing. Don’t delay, investigate your portfolio now.
  • Always read your prospectuses: It’s not enough just to read the morning paper and let your stockbroker do all the work. Your stockbroker might not be acting in your best interests. Make sure you read through the prospectus for each and every security you invest in. Always ask for help if you don’t know what something is.

Know Your Rights

The Financial Industry Regulatory Authority (FINRA), which holds stockbrokers and brokerage firms accountable for unsuitable investment advice and fraud, sternly punishes investment advisors and brokerage firms for unsuitable and fraudulent reverse convertible bond sales.

When an investor files a claim for “nest egg slasher” fraud, the unsuitability of the investment advice is a major issue, therefore FINRA Rule 2111 and FINRA Rule 2090 will apply to most reversible claims. To learn more about the doctrine of suitability, and unsuitability claims in general, you can read about this important legal issue here.

Do you suspect your financial loss was caused by a reverse convertible note fraud?

Try and Get Your Money Back

If you suffered investment declines due to the fraudulent actions of your stockbroker, you deserve financial compensation. Victims may qualify for a full or partial refund of the original amount invested, in addition to other compensation.

Financial damages can be economically crippling, but the realization you were lied to and played for a ‘sucker’ can be emotionally devastating. If you have fallen victim to this kind of fraud, it’s important to remember this is not your fault!

Pursuing a stock fraud claim will teach Wall Street brokerage firms it’s unacceptable to prey upon innocent consumers. Your claim may even prevent others from suffering as you have by forcing Wall Street brokerage firms to conduct business with honesty and integrity.

Contact Us

You may be eligible to receive compensation regardless of whether you sold or continue to hold the securities at issue. Contact us today to set up a free consultation. We will listen to your story, answer any questions you may have and discuss your legal rights and options.