Reverse convertibles: the disclosure debate

Reverse convertible securities in the US have been the subject of both harsh criticism and subsequently intense regulatory scrutiny. The stock market gyrations of late 2008 into 2009 caused the majority of reverse convertible securities to knock out, setting off a firestorm that singed retail investors’ portfolios and set off regulators’ smoke alarms. Could enhanced reverse convertible disclosure reverse the damage? Lori Pizzani reports

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How to get the right balance of quantity and quality of disclosure?

Reverse convertible securities have been the most prolifically issued structured note in the US in the past few years. High-net-worth investors with a bullish viewpoint on a stock can reach out to potential issuers through the reverse inquiry process and choose the structured note linked to an underlying of choice. Moreover, mainstream retail investors have been flocking to reverse convertibles, drawn in by the high coupons being offered on well-known names.

But cases have come to light of mis-selling and brokers overloading investors' portfolios with reverse convertible securities while being largely unsupervised as to the suitability of these sales. In addition, many investors have pleaded that they did not really understand the investments they bought into - including the knockout feature that left them holding greatly devalued stock.

The structures are also vulnerable to criticism of high fees that necessitate a link to high-volatility stocks in order to offer a sufficient level of return once the fee is extracted, according to Tim Mortimer, managing director of Future Value Consultants in London.

Reverse convertibles have also been criticised for their apparent lack of disclosure regarding the underlying stocks. One case that caused an outcry in the media was a reverse convertible note issued by JP Morgan in 2010 linked to television recorder manufacturer Tivo, which subsequently knocked out. The Tivo stock price fell due to a district court ruling against the company resulting from a patent dispute. Critics were alarmed that the product literature did not mention the ongoing patent dispute. However, that particular note was issued in response to a reverse inquiry from an investor with an existing viewpoint on Tivo, meaning no marketing to investors was involved. The patent dispute was eventually resolved in April this year, with Tivo receiving a $500 million settlement.

The past 18 months have seen US regulators - including the Securities and Exchange Commission (SEC), which governs all structured notes that issuers offer for sale, and the Financial Industry Regulatory Authority (Finra), which governs broker-dealers and structured products sales -increase their scrutiny of reverse convertibles. They have been particularly concerned about the suitability of products offered to individual investors, and about brokerage representatives presenting fair and balanced details to prospective investors.

The question is therefore whether expanded or enhanced disclosure for reverse convertible securities - particularly related to an underlying - would really benefit investors? If so, how much information represents the ‘Goldilocks' level - not too little, not too much, but just right? Should minimal information be provided to sophisticated investors seeking to express a viewpoint on a company and who have familiarity with reverse convertibles, and more in-depth information be provided to mainstream ‘mom-and-pop' retail investors? Moreover, should the distributor bear more responsibility for providing enhanced information to retail investors?

 

Previous disclosure reform

In December 2005, the structured products industry welcomed the Securities Offering Reform that modernised the registration process for offerings and communication documents for certain SEC-registered securities. It allowed issuers to ditch bulky product prospectuses and consolidate information into much shorter offering documents by using the free writing prospectus (FWP) format. The new format, in recognition of the widespread availability and use of electronic information, allowed for new structured product offerings to incorporate references and links to base prospectuses and supplements already filed with the SEC. An earlier, no-action letter permitted issuers to provide summaries of underlyings and links to information on the SEC's Edgar database.

Securities and Exchange Commission and Finra rules mandated specific disclosure, but over the years issuers have generally adopted a pattern in terms of what is disclosed where and in what format. Moreover, issuers must present materially correct information, not omit important information, and must present it in a fair and balanced manner.

"The market has gone from 40-50 page prospectuses to four-to-seven pages in a FWP. The quality of the information now is better than 10 years ago," says Joe Inzerillo, director and counsel in the legal department for the global equities and commodity derivatives division of BNP Paribas in New York. "Brokers can look at the much shorter document to understand the structured product."

Offering documents for reverse convertible securities now provide examples galore for investors to see how payouts work under a variety of scenarios. "FWPs on reverse convertibles have hypothetical examples: if the barrier is breached or not breached, if the underlying is down 50%, what you'll receive in terms of a coupon and principal, and also what you would have received if you were directly invested in the stock," says Inzerillo.

Confusion does exist where investors think they'll always get their principal back, but that is a function of mis-selling rather than a lack of information about the possible payouts on a reverse convertible note, he says. "Retail investors generally do worse if they had a direct investment in the underlying stock."

In addition, even if the underlying security does knock out, investors often forget those higher-than-market-rate coupons they had been receiving as compensation for the risk. What's more, they still own shares of the stock, which could appreciate in the future, say industry participants.

Inzerillo suggests the insertion of a clause along the following lines: "If the product declines by 30% you will lose money, but you did get an above market coupon of X% that is directly related to the volatility of the underlying stock." Issuers could also make it clearer that the higher the coupon, the riskier the product, he says.

Some industry participants also agree on the adoption of a single, standardised offering document that could apply to many structured products. In addition, a colour-code or traffic-light system could be developed, they say, with each colour representing a different level of risk.

 

The Goldilocks approach?

Could it make sense to have two or more levels of reverse convertible security disclosure based upon the sophistication of the investor?

That could prove difficult, according to Anna Pinedo, partner at law firm Morrison & Foerster in New York. "An issuer may choose to offer a reverse convertible security directly to a sophisticated investor who has approached the issuer, and the issuer may provide more abbreviated disclosure in an exempt offering (such as for 144A securities) given the investor's level of sophistication," she says. "However, I would not foresee an issuer using different disclosures for the same notes issued from its registered note programme. Most want a consistent pattern of public disclosure.

"Transparency has become the buzzword, but more isn't always the answer. We never know if it's enough information and many continue to ask ‘have we got the mix right?' It's only after litigation that this is determined," she says.

Pinedo does not anticipate that issuers will start providing enhanced information about a reverse convertible's underlying stock. Most issuers simply rely on that company's public disclosures. "You shouldn't expect to see an issuer provide forward-looking statements about the underlying company either," she says.

Adding a great deal of information about the underlying for a reverse convertible note could be counter-productive and result in a return to the voluminous offering documents of yore, according to many industry executives.

"The FWP was the single best thing that happened," says one structured products executive. "Having to read through a 116-page prospectus is going to dampen investor enthusiasm and isn't going to compel investors to read more. Even with the shorter FWP, I don't believe there is enough reading going on now." Although a lot of information is available, issuers are relying on what the underlying firms have filed, rather than adding their own backward- and forward-looking details. That could turn the information into a quasi-research paper -something few issuers are hoping to do, he cautions. Moreover, lengthier disclosure could become "information that covers the posterior of the issuer" but does nothing to help investors, he says.

According to Nick Parcharidis, managing director and Americas sales head at Citi Cross Asset Group in New York, best-in-class business practices require attention to disclosure combined with offering the right selection of reverse convertible securities. Those two ingredients must dovetail toward allowing investors to create laddered income portfolios and diversify their equity risk.

"We spend a lot of time and effort making sure our offering materials meet and exceed disclosure standards," says Parcharidis. "But if we feel there is some ambiguity or concern regarding a certain underlying stock, we won't roll that name out," he says.

Each month, Citi reviews stocks that are among the highest-rated overall by the firm for potential equity-linked securities offerings. Stocks with a speculative rating are never selected as note underlyings. Due diligence includes choosing up to three stocks each month from different sectors that are household names that Citi presumes clients will want to own, along with deciding if a note can be created with a coupon of at least 8% given the stock's volatility, says Parcharidis.

"I don't think you can ever give enough information to retail investors," says another US structured products executive. But the level of discussion and depth of information required depends on the distribution channel.

The proper amount of information depends on the investor's sophistication, but "analysis has to be done at the point of sale," says the executive. Intermediaries, including private bankers, relationship managers, registered investment advisers or broker-dealer representatives, should be discussing the product's full risks and showing investors the worst-case scenario, he says. "This becomes an issue in difficult markets. Very rarely do you see this concern in bull markets."

Suitability and disclosure go hand in hand, however. "If the investment is not suitable, it doesn't matter what the level of product disclosure is," says Alice Yurke, partner at law firm Ashurst in New York. "At the end of the day you come back to suitability."

Suitability issues are at the forefront of regulators' minds in the US right now. The SEC has proposed a new fiduciary standard for broker-dealer representatives that could impose upon them the equivalent fiduciary standards to which registered investment advisers are now held - namely, that they must treat other peoples' money with the same care as if it were their own (see feature, pages 28-30).

Moreover, Finra has reminded member firms that proper suitability analysis must take place before investment products - including reverse convertible securities - are sold. This includes assessing whether such investments are generally suitable for anyone the firm serves, then ensuring that a specific investment product meets the risk profile, time horizon, tax needs, and so on, of a particular client, says Yurke.

Even if a strict standard were to be applied, however, it is not incumbent upon the broker-dealer or issuer to provide every piece of information about the underlying, even if it is material, says Yurke. "If you say too much, it could be dilutive." The goal is not information overload.

 

Quality versus quantity

It is important to note a distinction between the quality of the disclosure and the quantity of disclosure. "I think it is important for the structured products industry to have plain English disclosures for retail investors. People have to understand what they are buying," says Jake Zamansky, a New York-based attorney with Zamansky & Associates, which has represented investors burned by reverse convertible securities. Many clients have admitted that they did not understand that the firm issuing the reverse convertible with an appealingly high coupon could put a beaten-up stock to them if the market fell, he says. "They have to understand that it's unsuitable for them if they are unwilling to hold a depreciated stock versus holding a fixed-income security."

Furthermore, Zamansky says brokers must be rigorously educated about these investments, perhaps through a structured products module added to the Series 7 broker's licensing curriculum and continuing education. They must also be taught how to best explain them to investors. "The sales pitch doesn't include the product's risks," he says.

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