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Univ. of Toledo College of Law

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Tuesday, February 16, 2010

FINRA Settles Enforcement Action Against H&R Block Financial Advisors for Sales of RCNs

FINRA announced its first enforcement action involving the sales of reverse convertible notes (RCNs) — fining H&R Block Financial Advisors, Inc., (n/k/a Ameriprise Advisor Services, Inc.) $200,000 for failing to establish adequate supervisory systems and procedures for supervising sales of RCNs to retail customers. FINRA also fined and suspended H&R Block broker Andrew MacGill for making unsuitable sales of RCNs to a retired couple. The firm was ordered to pay $75,000 in restitution to the couple for losses they incurred.

 At the same time, FINRA released an Investor Alert, Reverse Convertibles - Complex Investment Vehicles, to educate retail investors about how these products work, what risks they involve and what factors to consider before investing in an RCN. FINRA also issued Regulatory Notice 10-09, reminding firms of their sales practice obligations when recommending or selling RCNs to retail investors.

 An RCN is a structured product that typically consists of a high-yield, short-term note of an issuer and effectively a put option that is linked to the performance of an unrelated, or "linked," asset - usually a single common stock, but sometimes a basket of stocks, an index or some other asset. As a general rule, upon maturity of an RCN, the investor will receive either his full principal investment or a predetermined number of shares of the linked equity (which may be worth less than the principal investment), depending on the performance of the linked equity. Generally speaking, the higher the coupon rate, the higher the expected volatility of the linked equity and the greater the likelihood of the investment resulting in payment of shares. Reverse convertibles not only come with the risks that fixed income products ordinarily carry, such as issuer default and inflation risk, but with additional risks of the underlying asset, which can depreciate or even become worthless. The initial investment for most RCNs is $1,000 per unit and most RCNs have maturity dates ranging from three months to one year.

 In the enforcement matter, FINRA found that during the period from January 2004 through December 2007, H&R Block engaged in sales of RCNs without having a system or procedures in place to effectively monitor customer accounts for potential over-concentrations in RCNs. As a result, the firm failed to detect and respond to indications of potential over-concentration in RCNs in numerous customer accounts.

 FINRA found that H&R Block utilized an automated surveillance system to facilitate its suitability review of securities transactions and to monitor customer accounts for potentially unsuitable positions and activity. The system would flag for review any transaction or account meeting certain parameters established by the firm relating to, for example, account turnover and concentration levels in a particular security or class of security. The firm's system, however, was not configured or designed to monitor RCN transactions or RCN positions in customer accounts and the firm did not establish an effective alternative means to do so. As a result, H&R Block failed to detect and respond to indications of potentially unsuitable RCN concentration levels in numerous customer accounts. Additionally, the firm failed to provide sufficient guidance to its supervising managers on how to assess suitability in connection with their brokers' recommendation of RCNs.

 FINRA found that the retired couple receiving restitution had, on MacGill's recommendation, invested nearly 40 percent of their total liquid net worth in nine RCNs. This exposed the customers to a risk of loss that was inconsistent with their investment objectives and risk tolerance and which ultimately resulted in substantial loss. FINRA suspended MacGill from associating with any FINRA regulated firm in any capacity for a period of 15 days, fined him $10,000, and ordered him to disgorge $2,023 in commissions that he earned from his sales of RCNs to the couple.

 In concluding this settlement, H&R Block and MacGill neither admitted nor denied the charges, but consented to the entry of FINRA's findings.


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