Billions of dollars in corporate bonds sold to retail investors come with an unusual provision that could be used to generate a fast profit. There’s just one catch: Investors must team up to buy the bonds with someone who is about to die
American International Group Inc., Bank of America Corp., Caterpillar Inc., General Electric Co.’s GE Capital unit and other major U.S. companies often issue bonds with what is known as a survivor’s option.
In a little-known practice, investors can recruit a terminally ill person and together they can scoop up these bonds on the open market at a discount. When the ailing bondholder dies, the surviving co-owner can then redeem them at face value and potentially turn a quick profit.
Companies have typically included the macabre provision as a way to allay fears among ordinary individual investors—elderly couples who might worry that one spouse could die before the bonds mature, possibly exposing the survivor to a loss.
But the market’s turmoil has made this arrangement more attractive for professional investors, since some bonds are trading at a steep discount. Legal and financial experts say there is nothing to prevent investors from buying the bonds with a dying relative or even a stranger who is terminally ill.
It isn’t clear how many investors have piled into such bonds since the financial crisis hit, which initially pushed some below 50 cents on the dollar.
Prices have rebounded from their lows. But some so-called survivor’s-option corporate bonds issued by auto lender GMAC Financial Services, AIG unit American General Financial Services and student-loan provider SLM Corp. are still being offered at discounts of more than 20%, according to Knight BondPoint, a unit of Knight Capital Group Inc.
Companies typically issue the bonds because they want to tap into a regular, stable funding source through retail investors. Such companies often sell a small amount of bonds each week, say $25 million, through retail brokers.
Usually, there are two ways an investor can cash in a bond: by selling it to another investor on the open market, or by waiting until the issuer redeems the bond upon its maturity.
One investor who scored big on the money-back guarantee is Joseph A. Caramadre, an estate-planning lawyer in Cranston, R.I. From 2006 to 2009, Mr. Caramadre recruited several dozen terminally ill people to serve as joint brokerage-account holders. He then bought survivor’s-option bonds trading below face value for each account, according to Mr. Caramadre’s lawyer and federal court records filed in Providence, R.I., over how to pay out proceeds from the investments.
Robert G. Flanders Jr., Mr. Caramadre’s lawyer, said that his client specializes in finding obscure but legal loopholes in financial products. Mr. Caramadre, his family and investors, he said, have put about $10 million into corporate bonds with a survivor’s option—successfully collecting on many of the guarantees. In one instance, Mr. Caramadre’s wife paid $421,000 for bonds with a face value of $605,000, including from two AIG units. She then asked for them to be redeemed for the full amount after her co-owner died less than a year later.
There’s nothing in a typical prospectus that would prohibit such deals, said Edward Best, an attorney at Mayer Brown LLP in Chicago who has worked on bond offerings with survivor’s-option provisions. While issuers didn’t intend for them to be used to make a quick buck, he said, “there are people out there who will figure out how to game almost anything in the world.”
An AIG spokesman said the company wasn’t aware of the practice until it learned of Mr. Caramadre’s activities. The bonds’ fine print doesn’t prohibit such activity, the spokesman added.
According to underwriter Incapital LLC, there are $83 billion in retail-oriented bonds outstanding, most with a survivor’s option. “Over the years, the survivor’s option has proven to be a welcome benefit for individual investors that helps to mitigate market risk,” said a spokesman for the Chicago company. The situation with Mr. Caramadre is “an isolated incident,” he said.
Many of the bonds come with minimum holding periods, and issuers have the right to limit redemptions. That means an investor rush to redeem the bonds could delay payment. Investors also can lose if the issuer defaults, though that is rare.
The corporate-bond strategy used by Mr. Caramadre, who was the subject of a Page One article in The Wall Street Journal last month about variable annuities, has resulted in two civil suits related to the survivor’s option in U.S. District Court in Rhode Island. In both cases, Kane Reid Securities Group Inc., the Boca Raton, Fla., parent of discount broker TradeKing, asked a judge to decide who should be paid the proceeds of a bond redemption triggered by a survivor’s option: the dead owner’s heirs or a living co-owner (the latter being an associate or client of Mr. Caramadre).
According to court filings, Raymour Radhakrishnan, an employee of Mr. Caramadre, opened a joint brokerage account in February 2009 with a 77-year-old Naples, Fla., resident named Caterina Nero-Franco, buying at least 13 different retail bonds.
Mr. Radhakrishnan snapped up bonds of American General with a face value of $100,000 for about 50 cents on the dollar, according to court documents and data from BondDesk Group LLC, a Mill Valley, Calif., firm that runs an electronic bond-trading marketplace. He paid $47,000 for GMAC bonds with a face value of $116,000.
Ms. Nero-Franco died 10 days after the account was opened. A month later, Mr. Radhakrishnan filed to redeem all the bonds for face value. In September, a federal judge told TradeKing to turn over the proceeds to Mr. Radhakrishnan, concluding the case.
The $800,000 invested in the joint brokerage account produced a gross profit of $350,000, according to Mr. Flanders, the lawyer representing Mr. Caramadre. The heirs of Ms. Nero-Franco, a friend of the Caramadre family, received $88,000 of the proceeds, Mr. Flanders said.
A lawyer for Ms. Nero-Franco’s estate confirmed the arrangement. A lawyer for Mr. Radhakrishnan didn’t respond to messages seeking comment.
The second lawsuit, which was filed last month over a similar redemption claim and names Mr. Caramadre’s wife as a defendant, hasn’t been decided. Mr. Flanders, who represents her in that suit, asked a judge last week to dismiss the case.
Neither Mrs. Caramadre or the bond issuers also listed as defendants are accused of wrongdoing, but the brokerage firm again wants help from the judge on who should get money triggered by a survivor’s option.
Mr. Caramadre hasn’t always come out ahead with the survivor’s-option strategy. He suffered losses after buying Lehman Brothers Holdings Inc. bonds before the firm’s collapse in 2008, his lawyer said. And some issuers—which he declined to name—have delayed payouts.