INVESTOR RIGHTS
FOR THE 21ST
CENTURY
By Mark E. Maddox, Esq. and Andrew J. Stoltmann, Esq.
Public Investors Arbitration Ba...
Copyright © 2001 by the Public Investors Arbitration Bar Association
All rights reserved
PUBLISHER’S DISCLAIMER: Every eff...
DEDICATION:
To the millions of investors who have been defrauded by unethical stockbrokers and brokerage
firms.
v
Introduction
Investors lose billions of dollars every year due to the fraud, misconduct or simple negligence of
their fi...
vi
PIABA Membership Information
PIABA was established in 1990 as an educational and networking organization for securities...
vii
provide the names of PIABA attorneys practicing in the area for referral purposes. While this is
not the main purpose ...
! Check Enclosed ! Visa ! MasterCard (Note: We do not accept American Express.)
Name on Credit Card_______________________...
xi
INVESTORS RIGHTS
FOR THE 21st
CENTURY
Table Of Contents—By Section
Securities Industry Q1 . . . . . . . . . . . . . . ....
Maddox / Stoltmann
xii
Investment Products and Abuses
Stocks Q18 . . . . . . . . . . . . . . . . . . . . . . . . . 9
Bonds...
Investor Rights for the 21st
Century
xiii
Unauthorized Trading
Defined Q45 . . . . . . . . . . . . . . . . . . . . . . . ....
Maddox / Stoltmann
xiv
Investor Contact Q74 . . . . . . . . . . . . . . . . . . . . . . . . 44
Attorney Compensation Q75 ....
Investor Rights for the 21st
Century
xv
Arbitration Advantages Q104 . . . . . . . . . . . . . . . . . . . . . . . 60
Secur...
Maddox / Stoltmann
xvi
Damages
Types of Damages Q136 . . . . . . . . . . . . . . . . . . . . . . . 73
Interest Q137 . . . ...
Investor Rights for the 21st
Century
1
The Securities Industry
1) Is there one type of investment professional who is most...
Maddox / Stoltmann
2
4) How do investors go about recovering their investment losses?
Usually through securities arbitrati...
Investor Rights for the 21st
Century
3
An investor, even after checking with the NASD, should also call the state securiti...
Maddox / Stoltmann
4
7) Does the Central Registration Depository accurately reflect all
broker wrongdoings?
No. The CRD is...
Investor Rights for the 21st
Century
5
management, by the SEC. Even accountants and lawyers who provide financial advice
m...
Maddox / Stoltmann
6
firms often pay higher commissions for the sale of riskier investments and 15 percent of
those survey...
Investor Rights for the 21st
Century
7
14) Are discount brokerage firms immune from defrauding
investors?
Absolutely not. ...
Maddox / Stoltmann
8
In February of 2001, one of the nation’s largest online firm’s was fined $225,000 by the
New York Sto...
Investor Rights for the 21st
Century
9
The Investment Products and their Abuses
18) Stocks
The most common disputes in arb...
Maddox / Stoltmann
10
19) Bonds
Bonds are one of the investments that are the least understood by investors. As a result,
...
Investor Rights for the 21st
Century
11
usually receive more in compensation for selling lower quality bonds, which often ...
Maddox / Stoltmann
12
percent. In other words, the average mutual fund bond investor did better than the
average mutual fu...
Investor Rights for the 21st
Century
13
receives a margin call and extensive loses are sustained. Brokerage firms and brok...
Maddox / Stoltmann
14
The best evidence of how attractive annuities are to financial representatives is that in
1998, appr...
Investor Rights for the 21st
Century
15
firm? Put the investor into a fee-based account and charge the investor up to thre...
Maddox / Stoltmann
16
gain their trust – knowing that it’s human nature to trust people who are like you – and
then steal ...
Investor Rights for the 21st
Century
17
the schemes collapse. Ponzi schemes are the legacy of Italian immigrant Charles Po...
Maddox / Stoltmann
18
The Most Common Types of Arbitration Complaints
26) What securities are involved in arbitrations?
Se...
Investor Rights for the 21st
Century
19
29) How common are misrepresentations and omissions?
In 2000, there were approxima...
Maddox / Stoltmann
20
33) How do arbitrators decide whether there is a fiduciary
relationship or not?
To determine the dut...
Investor Rights for the 21st
Century
21
36) How common are suitability claims?
In 2000, there were 900 cases filed against...
Maddox / Stoltmann
22
that individual investor. Often, brokers use compensation as the primary means for
determining suita...
Investor Rights for the 21st
Century
23
when a broker recommends an investment while NYSE Rule 405 applies anytime any
inv...
Maddox / Stoltmann
24
investors. In order to protect the least experienced investors, the NASD needs to clearly
extend the...
Investor Rights for the 21st
Century
25
implicit sales solicitation and an encouragement to trade. The technology offered ...
Maddox / Stoltmann
26
42) What is the NASD’s position on online suitability obligations for
e-brokers?
In March of 2001, t...
Investor Rights for the 21st
Century
27
shorting technology stocks, online firms should have the obligation, at a minimum,...
Maddox / Stoltmann
28
representatives and associated persons that are reasonably designed to achieve
compliance with appli...
Investor Rights for the 21st
Century
29
46) How common are unauthorized trading abuses?
Investors filed approximately 611 ...
Maddox / Stoltmann
30
care that a broker owes his client is at least “reasonable care.” It is left up to the
arbitrators t...
Investor Rights for the 21st
Century
31
broker makes a commission for each buy or sell that occurs in a client’s account. ...
Maddox / Stoltmann
32
b) the relationship between the customer and the broker, that is, whether it is an
arms length one o...
Investor Rights for the 21st
Century
33
The three most common real world methods for determining excessive trading are the...
Maddox / Stoltmann
34
would lead to the conclusion that a turnover rate in excess of three for any account would
be eviden...
Investor Rights for the 21st
Century
35
historical return) is going towards paying a stockbroker’s commissions. That is si...
Maddox / Stoltmann
36
filing of the statement of claim have had a market value, if left undisturbed, in
considerable exces...
Investor Rights for the 21st
Century
37
Charles Schwab) between 1991 and 1996. The study concluded that the most active
ac...
Maddox / Stoltmann
38
on the top performing days and therefore miss out on most of the market returns.
Unfortunately, stoc...
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Investor rights for the 21st century
Upcoming SlideShare
Loading in...5
×

Investor rights for the 21st century

950

Published on

Investors lose billions of dollars every year due to the fraud, misconduct or simple negligence of their financial advisers. However, most investors take no action to recover these losses. Some investors are too embarrassed to tell anyone about their losses. Others don't want their spouses or family members to find out. Most investors don't know where to go to find out whether anything can be done to help them. In most instances, their tried and true tax advisers and/or general practice attorneys lack the knowledge or experience to adequately apprise them of their rights and options.

The Stoltmann Law Offices exclusively represents investors from across the country in securities litigation and arbitration actions including claims for fraud, unsuitable investment recommendations, excessive trading, churning, unauthorized trading, breach of fiduciary duty and misrepresentations and omissions. Investment losses often have a devastating impact on investors whose financial advisor, stockbroker, insurance agent or corporate management team failed to comply with their fiduciary duties and obligations. The failure to diversify a portfolio, unsuitable investment recommendations or a stockbroker who failed to disclose the risks associated with an investment all may be actionable claims under an investor’s state securities act entitling the investor to recovery of his or her losses, attorney fees, statutory interest and costs.
http://investmentfraud.pro

Published in: Investor Relations, Business
0 Comments
0 Likes
Statistics
Notes
  • Be the first to comment

  • Be the first to like this

No Downloads
Views
Total Views
950
On Slideshare
0
From Embeds
0
Number of Embeds
0
Actions
Shares
0
Downloads
5
Comments
0
Likes
0
Embeds 0
No embeds

No notes for slide

Investor rights for the 21st century

  1. 1. INVESTOR RIGHTS FOR THE 21ST CENTURY By Mark E. Maddox, Esq. and Andrew J. Stoltmann, Esq. Public Investors Arbitration Bar Association 2241 W. Lindsey Street, Suite 500 Norman, Oklahoma 73069 1-888-621-7484 www.PIABA.org
  2. 2. Copyright © 2001 by the Public Investors Arbitration Bar Association All rights reserved PUBLISHER’S DISCLAIMER: Every effort has been made in this publication to achieve accuracy. The law constantly changes and is subject to differing interpretations. Therefore, always consult with one’s own attorney and act only on his or her own professional legal advice. This publication is distributed with the understanding that neither the publisher nor the authors engaged in rendering any legal, investment, or other professional advice or services. The publisher and authors shall not be responsible for any damages from any inaccuracy or omission in this publication.
  3. 3. DEDICATION: To the millions of investors who have been defrauded by unethical stockbrokers and brokerage firms.
  4. 4. v Introduction Investors lose billions of dollars every year due to the fraud, misconduct or simple negligence of their financial advisers. However, most investors take no action to recover these losses. Some investors are too embarrassed to tell anyone about their losses. Others don't want their spouses or family members to find out. Most investors don't know where to go to find out whether anything can be done to help them. In most instances, their tried and true tax advisers and/or general practice attorneys lack the knowledge or experience to adequately apprise them of their rights and options. In 1990, the Public Investor Arbitration Bar Association ("PIABA") was established by investor attorneys to attempt to level the playing field between lawyers for the securities industry and those representing investors. When investors are referred to members of PIABA, there is a high probability they will be adequately advised of their rights and options regarding disputes with their financial advisers. Since 1987, the vast majority of disputes between investors and their brokers are required to be resolved through securities arbitration. This publication is intended to generally inform investors and their lawyers about securities arbitration and their rights within the process. It is intended to be a basic primer for securities arbitration, not a battle plan for complicated case specific strategy. Like any dispute resolution system, securities arbitration is far from perfect. Our friend and colleague Seth Lipner best captures the essence of these imperfections when he reminds us that "arbitration" and "arbitrary" are derived from the same root. Nevertheless, it is the only game in town for aggrieved investors and should be played on a level playing field, with all sides subject to the same rules.
  5. 5. vi PIABA Membership Information PIABA was established in 1990 as an educational and networking organization for securities arbitration attorneys who represent the public investor in securities disputes. While PIABA’s main purpose is further educating securities arbitration attorneys, its members are involved in promoting the interests of the public investor in securities and commodities arbitration. Mission The mission of PIABA is to promote the interests of the public investor in securities and commodities arbitration by protecting public investors from abuses in the arbitration process, such as those associated with document production and discovery; making securities and commodities arbitration as just and fair as systematically possible; and creating a level playing field for the public investor in securities and commodities arbitration. Membership Qualifications An applicant: • must be an attorney-at-law duly admitted to practice before the courts; • must be currently representing or in the past have represented at least one public investor in connection with his or her dispute with a securities or commodities brokerage firm; • must not be an employee of a securities or commodities brokerage firm; and • for the last year, neither the applicant nor his partners or associates, may have devoted twenty percent (20%) or more of their securities practice to representing securities or commodities industry clients against public investors. Benefits of Membership There are many rewards of membership in PIABA. The PIABA Quarterly is edited by Board Member L. Jerome Stanley and released in March, June, September and December. The Quarterly is subscribed to by over 400 attorneys, securities experts and consultants and CPA’s. In the fall of each year, PIABA sponsors an Annual Meeting. The Annual Business Meeting and election of directors is held at this meeting. Attorneys may receive continuing education hours for their participation at this meeting. Many PIABA members find this an excellent time to network and share ideas. Approximately 175 attorneys, securities experts and consultants attend this meeting annually. Investors and members are frequently referred to the PIABA web site at www.PIABA.org for information. From the Members Only area, members may post a message for all members on the PIABA Message Board, find uploaded cases or articles or information regarding the progress of PIABA committees and research arbitrators and past awards. PIABA members continue to utilize the Internet to communicate with each other via e-mail and member Websites. The PIABA membership roster is published and sent bi-annually to PIABA members, listing the business address, telephone and fax numbers, and e-mail address thus providing rapid access to members of the organization. Currently, the Securities and Exchange Commission and several State Securities Commissions recommend to investors they contact PIABA for attorney assistance. Upon request, PIABA will
  6. 6. vii provide the names of PIABA attorneys practicing in the area for referral purposes. While this is not the main purpose of PIABA, it is a service we provide to investors and our members. Although the membership roster is published to members bi-annually, it is updated daily for referral purposes. PIABA 2241 W. Lindsey Street, Suite 500 Norman, OK 73069 Office: 1-405-360-8776 toll free: 1-888-621-7484 E-mail: piaba@piaba.org www.PIABA.org
  7. 7. ! Check Enclosed ! Visa ! MasterCard (Note: We do not accept American Express.) Name on Credit Card________________________________________________Amount Enclosed_____________ Credit Card Number___________________________________ Expiration Date_____________________________ Signature_____________________________________________________________________________________ If you have more than one member in your firm applying for membership, please fill out a separate form for each. Thank you. Please enclose membership dues of $295.00. Public Investors Arbitration Bar Association (“PIABA”) Membership Application Name: _____________________________________________________________ Law Firm: _____________________________________________________________ Office Address: _____________________________________________________________ _____________________________________________________________ Office Phone: ___________________________ FAX: ___________________________ Toll Free Number: ____________________________________________________________ E-mail: ___________________________ Website: _________________________ Bar Information States Admitted to Practice and Dates: ____________________________________________ State Bar No(s). ______________________________________________________________ Please state if your license to practice law in any jurisdiction has ever been suspended or revoked: Yes_______ No_______ Nature of Your Practice Number of Years Practicing in the Field of Securities/Commodities Arbitration: _____________ Percentage of Overall Practice that Consists of Securities/Commodities Arbitration: ________ As to the securities/commodity portion of your practice (A & B should equal 100%): A. Percentage of Practice Representing Public Investors: __________________ B. Percentage of Practice Representing Securities/Commodities Firms: _______ As to your defense practice in the securities/commodities fields, please attach a list of all such cases in the last two years. Describe the kind of case (customer or industry) and the party your represented. Securities Licenses: If you have had any NASD or CFTC licenses, please state the date each was received, and attach a list of all firms with which you were affiliated, and pertinent dates. Please attach a current copy of your U-4. Affidavit I am an attorney-at-law admitted to practice before the courts and currently employed with an established law office. I am not affiliated with an ‘arbitration service.’ I am currently representing or in the past have represented at least one public investor in connection with his or her dispute with a securities or commodities brokerage firm. I am eligible for membership in PIABA if, and only if, at least 80 percent of my work involving securities industry/customer disputes and at least 80 percent my current law firm’s work involving securities industry/customer disputes is performed on behalf of investors. “Securities industry/customer disputes” shall mean disputes between investors, on the one hand, and any one or more the following, on the other: securities and commodities industry participants (licensed or unlicensed), securities issuers, financial counselors, and persons alleged to have liability for the acts or omissions of any of the foregoing. Any uncertainty, ambiguity, or question as to whether certain representation does or does not involve securities or commodities industry participants will be presumed to be industry representation. The percentage of my work and my firm’s work in securities industry/customer disputes shall be the percentage of hours spent rather than the percentage of revenues generated or any other measure; and the relevant time period for determining that percentage shall run from January 1 of the year preceding the date on which the determination is made to the date on which the determination is made, inclusive. I have the continuing obligation to notify PIABA immediately of any changes which affect the member’s compliance with the 80-20 Rule. I affirm that the information set forth herein is true and accurate. Signature___________________________________________________ Date__________________________ April 2, 2001
  8. 8. xi INVESTORS RIGHTS FOR THE 21st CENTURY Table Of Contents—By Section Securities Industry Q1 . . . . . . . . . . . . . . . . . . . . . . . . . 1 Investment Products and their Abuses Q18 . . . . . . . . . . . . . . . . . . . . . . . . . 9 Most Common Types of Arbitration Complaints Q26 . . . . . . . . . . . . . . . . . . . . . . . . 18 Attorneys and Expenses Q72 . . . . . . . . . . . . . . . . . . . . . . . . 43 Initiating Arbitration Q77 . . . . . . . . . . . . . . . . . . . . . . . . 46 Pre-Hearing Discovery Q85 . . . . . . . . . . . . . . . . . . . . . . . . 50 Pre-Hearing Depositions Q91 . . . . . . . . . . . . . . . . . . . . . . . . 56 Compulsory Arbitration Q93 . . . . . . . . . . . . . . . . . . . . . . . . 56 Superiority of Arbitration Q100 . . . . . . . . . . . . . . . . . . . . . . . 59 Hearing Process Q112 . . . . . . . . . . . . . . . . . . . . . . . 63 Defenses Q126 . . . . . . . . . . . . . . . . . . . . . . . 68 Damages Q136 . . . . . . . . . . . . . . . . . . . . . . . 73 Award Q142 . . . . . . . . . . . . . . . . . . . . . . . 76 Mediation Q148 . . . . . . . . . . . . . . . . . . . . . . . 78 Table of Contents—By Question Likelihood of Fraud Q1 . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Problem Significance Q2 . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Underreporting of Fraud Q3 . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Recovering Losses Q4 . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Broker Background Q5 . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Financial Planner Background Q6 . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Central Registration Depository Accuracy Q7 . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Broker, Investment Adviser and Financial Planner Q8 . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Regulation of Investment Advisors Q9 . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Unethical Investment Professionals Q10 . . . . . . . . . . . . . . . . . . . . . . . . . 5 Reason for Investment Abuses Q11 . . . . . . . . . . . . . . . . . . . . . . . . . 5 Investor Ignorance Q12 . . . . . . . . . . . . . . . . . . . . . . . . . 5 Brokerage Firm Problems Q13 . . . . . . . . . . . . . . . . . . . . . . . . . 6 Discount Brokerage Firm Problems Q14 . . . . . . . . . . . . . . . . . . . . . . . . . 7 Online Brokerage Firm Problems Q15 . . . . . . . . . . . . . . . . . . . . . . . . . 7 Accountant Abuses Q16 . . . . . . . . . . . . . . . . . . . . . . . . . 8 Bank Abuses Q17 . . . . . . . . . . . . . . . . . . . . . . . . . 8
  9. 9. Maddox / Stoltmann xii Investment Products and Abuses Stocks Q18 . . . . . . . . . . . . . . . . . . . . . . . . . 9 Bonds Q19 . . . . . . . . . . . . . . . . . . . . . . . . 10 Mutual Funds Q20 . . . . . . . . . . . . . . . . . . . . . . . . 11 Margin Q21 . . . . . . . . . . . . . . . . . . . . . . . . 12 Annuities Q22 . . . . . . . . . . . . . . . . . . . . . . . . 13 Options Q23 . . . . . . . . . . . . . . . . . . . . . . . . 14 Fee Based Accounts Q24 . . . . . . . . . . . . . . . . . . . . . . . . 14 Other Investment Products Q25 . . . . . . . . . . . . . . . . . . . . . . . . 15 Common Types of Arbitration Complaints Securities at Issue Q26 . . . . . . . . . . . . . . . . . . . . . . . . 18 Compensation for Claimants Q27 . . . . . . . . . . . . . . . . . . . . . . . . 18 Misrepresentations and Omissions Defined Q28 . . . . . . . . . . . . . . . . . . . . . . . . 18 Frequency Q29 . . . . . . . . . . . . . . . . . . . . . . . . 19 Examples Q30 . . . . . . . . . . . . . . . . . . . . . . . . 19 Breach of Fiduciary Duties Defined Q31 . . . . . . . . . . . . . . . . . . . . . . . . 19 Frequency Q32 . . . . . . . . . . . . . . . . . . . . . . . . 19 Criteria Q33 . . . . . . . . . . . . . . . . . . . . . . . . 20 Responsibilities Q34 . . . . . . . . . . . . . . . . . . . . . . . . 20 Suitability Defined Q35 . . . . . . . . . . . . . . . . . . . . . . . . 20 Frequency Q36 . . . . . . . . . . . . . . . . . . . . . . . . 21 Causes Q37 . . . . . . . . . . . . . . . . . . . . . . . . 21 NASD Rule 2310 Q38 . . . . . . . . . . . . . . . . . . . . . . . . 22 NYSE Rule 405 Q39 . . . . . . . . . . . . . . . . . . . . . . . . 22 Difference between NASD and NYSE Rule Q40 . . . . . . . . . . . . . . . . . . . . . . . . 22 Online Suitability Obligation Q41 . . . . . . . . . . . . . . . . . . . . . . . 23 Online Suitability NASD Obligation Q42 . . . . . . . . . . . . . . . . . . . . . . . . 26 Failure to Supervise Duty to Supervise Q43 . . . . . . . . . . . . . . . . . . . . . . . . 27 Frequency Q44 . . . . . . . . . . . . . . . . . . . . . . . . 28
  10. 10. Investor Rights for the 21st Century xiii Unauthorized Trading Defined Q45 . . . . . . . . . . . . . . . . . . . . . . . . 28 Frequency Q46 . . . . . . . . . . . . . . . . . . . . . . . . 29 Discretionary Account Q47 . . . . . . . . . . . . . . . . . . . . . . . . 29 Negligence Defined Q48 . . . . . . . . . . . . . . . . . . . . . . . . 29 Frequency Q49 . . . . . . . . . . . . . . . . . . . . . . . . 30 Churning Defined Q50 . . . . . . . . . . . . . . . . . . . . . . . . 30 Frequency Q51 . . . . . . . . . . . . . . . . . . . . . . . . 30 Occurrence Q52 . . . . . . . . . . . . . . . . . . . . . . . . 30 Motivation to Churn Q53 . . . . . . . . . . . . . . . . . . . . . . . . 30 Churning Elements Q54 . . . . . . . . . . . . . . . . . . . . . . . . 31 Control Types Q55 . . . . . . . . . . . . . . . . . . . . . . . . 31 Implied Control Q56 . . . . . . . . . . . . . . . . . . . . . . . . 31 Investor Education or Occupation Q57 . . . . . . . . . . . . . . . . . . . . . . . . 32 Excessive Activity Q58 . . . . . . . . . . . . . . . . . . . . . . . . 32 Turnover Rate Q59 . . . . . . . . . . . . . . . . . . . . . . . . 33 Turnover Rate Threshold Q60 . . . . . . . . . . . . . . . . . . . . . . . . 33 Cost Equity Ratio Q61 . . . . . . . . . . . . . . . . . . . . . . . . 34 Cost Equity Ratio Threshold Q62 . . . . . . . . . . . . . . . . . . . . . . . . 34 In-And-Out Trading Q63 . . . . . . . . . . . . . . . . . . . . . . . . 35 Levels of Excessiveness Q64 . . . . . . . . . . . . . . . . . . . . . . . . 35 Churning Intent Q65 . . . . . . . . . . . . . . . . . . . . . . . . 35 Account Profitability Q66 . . . . . . . . . . . . . . . . . . . . . . . . 35 Churning Versus Excessive Trading Q67 . . . . . . . . . . . . . . . . . . . . . . . . 36 Probability of Successful Short Term Trading Q68 . . . . . . . . . . . . . . . . . . . . . . . . 36 Penny Stock Fraud Prevalence of Problem Q69 . . . . . . . . . . . . . . . . . . . . . . . . 41 Defined Q70 . . . . . . . . . . . . . . . . . . . . . . . . 42 Solving the Problem Q71 . . . . . . . . . . . . . . . . . . . . . . . . 42 Attorneys and Expenses Attorney Experience Q72 . . . . . . . . . . . . . . . . . . . . . . . . 43 Non-Attorney Representation Q73 . . . . . . . . . . . . . . . . . . . . . . . . 43
  11. 11. Maddox / Stoltmann xiv Investor Contact Q74 . . . . . . . . . . . . . . . . . . . . . . . . 44 Attorney Compensation Q75 . . . . . . . . . . . . . . . . . . . . . . . . 44 Arbitration Expenses Q76 . . . . . . . . . . . . . . . . . . . . . . . . 45 Initiating Arbitration Beginning Arbitration Q77 . . . . . . . . . . . . . . . . . . . . . . . . 46 Uniform Submission Agreement Q78 . . . . . . . . . . . . . . . . . . . . . . . . 46 Statement of Claim Q79 . . . . . . . . . . . . . . . . . . . . . . . . 46 Claims Under $25,000 Q80 . . . . . . . . . . . . . . . . . . . . . . . . 47 Statement of Claim and USA Q81 . . . . . . . . . . . . . . . . . . . . . . . . 47 Time to Answer Q82 . . . . . . . . . . . . . . . . . . . . . . . . 48 Single Arbitrator Q83 . . . . . . . . . . . . . . . . . . . . . . . . 48 Rule 10336 Q84 . . . . . . . . . . . . . . . . . . . . . . . . 49 Pre-Hearing Discovery Pre-Hearing Discovery Q85 . . . . . . . . . . . . . . . . . . . . . . . . 50 Changes in Pre-Hearing Discovery Q86 . . . . . . . . . . . . . . . . . . . . . . . . 50 NASD Discovery Guide Brokerage Firm Documents Q87 . . . . . . . . . . . . . . . . . . . . . . . . 51 NASD Discovery Guide Investor Documents Q88 . . . . . . . . . . . . . . . . . . . . . . . . 53 Problems Q89 . . . . . . . . . . . . . . . . . . . . . . . . 55 Pre-Hearing Exchange Q90 . . . . . . . . . . . . . . . . . . . . . . . . 55 Pre-Hearing Depositions Depositions Q91 . . . . . . . . . . . . . . . . . . . . . . . . 56 Deposition Options Q92 . . . . . . . . . . . . . . . . . . . . . . . . 56 Compulsory Arbitration Mandatory Arbitration Q93 . . . . . . . . . . . . . . . . . . . . . . . . 56 Arbitration Agreement Example Q94 . . . . . . . . . . . . . . . . . . . . . . . . 57 Arbitrator Need Q95 . . . . . . . . . . . . . . . . . . . . . . . . 57 Arbitrator Requirements Q96 . . . . . . . . . . . . . . . . . . . . . . . . 57 Arbitrator Compensation Q97 . . . . . . . . . . . . . . . . . . . . . . . . 58 Advantages Q98 . . . . . . . . . . . . . . . . . . . . . . . . 58 Arbitrator Pool Q99 . . . . . . . . . . . . . . . . . . . . . . . . 58 Superiority of Arbitration Fairness Q100 . . . . . . . . . . . . . . . . . . . . . . . 59 Imperfections Q101 . . . . . . . . . . . . . . . . . . . . . . . 60 Improvements Q102 . . . . . . . . . . . . . . . . . . . . . . . 60 Disadvantages to Court Q103 . . . . . . . . . . . . . . . . . . . . . . . 60
  12. 12. Investor Rights for the 21st Century xv Arbitration Advantages Q104 . . . . . . . . . . . . . . . . . . . . . . . 60 Securities Member Panelist Q105 . . . . . . . . . . . . . . . . . . . . . . . 61 Arbitration and Litigation Q106 . . . . . . . . . . . . . . . . . . . . . . . 62 Motions Q107 . . . . . . . . . . . . . . . . . . . . . . . 62 Arbitrator Selection Q108 . . . . . . . . . . . . . . . . . . . . . . . 62 Chairperson Selection Q109 . . . . . . . . . . . . . . . . . . . . . . . 63 Arbitrator versus Judges Q110 . . . . . . . . . . . . . . . . . . . . . . . 63 Arbitration Forum Selection Q111 . . . . . . . . . . . . . . . . . . . . . . . 63 Hearing Process Inside an Arbitration Q112 . . . . . . . . . . . . . . . . . . . . . . . 63 Arbitrator Questions Q113 . . . . . . . . . . . . . . . . . . . . . . . 64 Subpoenas Q114 . . . . . . . . . . . . . . . . . . . . . . . 65 Arbitration Guiding Principal Q115 . . . . . . . . . . . . . . . . . . . . . . . 65 Objections Q116 . . . . . . . . . . . . . . . . . . . . . . . 65 Arbitration Scheduling Q117 . . . . . . . . . . . . . . . . . . . . . . . 65 Stipulations Q118 . . . . . . . . . . . . . . . . . . . . . . . 66 Evidence Q119 . . . . . . . . . . . . . . . . . . . . . . . 66 Affidavits Q120 . . . . . . . . . . . . . . . . . . . . . . . 66 Arbitration Length Q121 . . . . . . . . . . . . . . . . . . . . . . . 67 Expert Witnesses Q122 . . . . . . . . . . . . . . . . . . . . . 67 Expert Attendance Q123 . . . . . . . . . . . . . . . . . . . . . . . 67 Pro Se Investors Q124 . . . . . . . . . . . . . . . . . . . . . . . 67 Disciplinary Referrals Q125 . . . . . . . . . . . . . . . . . . . . . . . 68 Defenses Investor Initiated Transactions Q126 . . . . . . . . . . . . . . . . . . . . . . . 68 Statute of Limitations Q127 . . . . . . . . . . . . . . . . . . . . . . . 69 When Applicable Q128 . . . . . . . . . . . . . . . . . . . . . . . 69 Eligibility Requirement Q129 . . . . . . . . . . . . . . . . . . . . . . . 69 Eligibility v. Statute of Limitations Q130 . . . . . . . . . . . . . . . . . . . . . . . 70 Statute of Limitations Abuses Q131 . . . . . . . . . . . . . . . . . . . . . . . 70 Estoppel, Waiver, Laches Q132 . . . . . . . . . . . . . . . . . . . . . . . 71 Failure to Complain Q133 . . . . . . . . . . . . . . . . . . . . . . . 71 “Happiness” or “Comfort” Letters Q134 . . . . . . . . . . . . . . . . . . . . . . . 71 New Account Application Q135 . . . . . . . . . . . . . . . . . . . . . . . 72
  13. 13. Maddox / Stoltmann xvi Damages Types of Damages Q136 . . . . . . . . . . . . . . . . . . . . . . . 73 Interest Q137 . . . . . . . . . . . . . . . . . . . . . . . 73 Attorney Fees Q138 . . . . . . . . . . . . . . . . . . . . . . . 74 “Well Managed Account” Q139 . . . . . . . . . . . . . . . . . . . . . . . 74 Punitive Damages Q140 . . . . . . . . . . . . . . . . . . . . . . . 74 Importance of Punitive Damages Q141 . . . . . . . . . . . . . . . . . . . . . . . 75 Award Time to Get Award Q142 . . . . . . . . . . . . . . . . . . . . . . . 76 Form of Award Q143 . . . . . . . . . . . . . . . . . . . . . . . 76 Arbitrator Flexibility of Awards Q144 . . . . . . . . . . . . . . . . . . . . . . . 77 Award Constraints Q145 . . . . . . . . . . . . . . . . . . . . . . . 77 Appealing Awards Q146 . . . . . . . . . . . . . . . . . . . . . . . 77 Finality of Awards Q147 . . . . . . . . . . . . . . . . . . . . . . . 78 Mediation Mediation Q148 . . . . . . . . . . . . . . . . . . . . . . . 78 Different than Arbitration Q149 . . . . . . . . . . . . . . . . . . . . . . . 78 Mediation Success Rates Q150 . . . . . . . . . . . . . . . . . . . . . . 79 Mediation as an Option Q151 . . . . . . . . . . . . . . . . . . . . . . . 79 Appendices Appendix 1: State Securities Offices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81 Appendix 2: Regulatory Agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87 Appendix 3: How To Avoid Problems With a Broker . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89 Appendix 4: Checklist Before Doing Business With a Broker . . . . . . . . . . . . . . . . . . . . . . . . . 91 Appendix 5: Mutual Fund Investing: Look at More Than a Fund's Past Performance . . . . . . . 93 Appendix 6: Certificates of Deposit: Tips for Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 Appendix 7: Day Trading: Your Dollars at Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 Appendix 8: Investment Advisers: What You Need to Know Before Choosing One . . . . . . 103 Appendix 9: Microcap Stock: A Guide for Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107 Appendix 10: NASD Code of Arbitration Procedure Appendix 11: Arbitrator Applications
  14. 14. Investor Rights for the 21st Century 1 The Securities Industry 1) Is there one type of investment professional who is most likely to defraud the public? No. Today, it is not just stockbrokers who defraud investors. As investors’ financial assets have exploded in recent years, to $27 trillion in 1999 from approximately $15 trillion in 1990, brokerage firms have attempted to position their employees not as “stockbrokers” but rather as “financial professionals.” Usually, this is a distinction without a significant difference. Regardless of what a firm calls its sales force, investors must be careful in their dealings with anyone in the securities or insurance industry. 2) How significant of a problem is securities fraud? Unfortunately, abuses in the securities industry are widespread. In 1999, the North American Securities Administration Association (NASAA), which represents state securities regulators, reported a 30 percent increase in fraud from the previous year. The group estimates that securities fraud costs American investors $10 billion a year, or $1 million every hour. The number of arbitration cases at the NASD alone has increased from 318 in 1980 to 5,558 in 2000. 3) Are securities abuses underreported? Yes. The overwhelming majority of all investment abuses are never reported. The cases that are actually filed against brokers, insurance agents and investment advisers are the very small tip of the iceberg. Often, investors feel embarrassed by their supposed gullibility or degree of trust that they placed in their broker. Investors often assume they are simply the victim of the market and there is nothing that can be done. However, if an investor is the victim of fraud by an investment professional, then they do have legal options.
  15. 15. Maddox / Stoltmann 2 4) How do investors go about recovering their investment losses? Usually through securities arbitration. Since 1987, the U.S. Supreme Court has allowed the securities industry to force investors into arbitration instead of court litigation. In arbitration, the decision of the arbitrators is binding and final. The arbitration proceeding is similar in many respects to a trial in a court of law with some notable exceptions. In arbitration, as in a trial in court, there are opening and closing statements, the presentment of evidence and witnesses, and a decision rendered by the panel. However, unlike court litigation, the rules of evidence are more relaxed and the arbitrators many times are concerned with what is fair and equitable. 5) How can investors check the background of their broker? One of the most important steps an investor should take when choosing a financial advisor is to examine the advisor’s background. To check out a broker, acquire a copy of the broker’s disciplinary and employment history from the National Association of Securities Dealers (800-289-9999) or from the state securities division (See Appendix 1). Another option is to log onto the NASD Regulation website (www.nasdr.com) where an investor can review brokers’ employment history, find out where they are licensed, determine what products they are registered to sell and request disciplinary records. Unfortunately, the NASD’s website section has numerous problems that often makes retrieving the information nearly impossible. Typically, the best source for retrieving information about a broker is through a state securities division. When reviewing a broker’s Central Registration Depository (CRD) report, first examine the broker’s disciplinary history. On the NASD website, this information will fall under the heading “Disclosure Events.” It includes civil or criminal actions by securities regulators, plus arbitration cases, lawsuits and settlements stemming from investor complaints. It also lists all investor complaints filed in the past 24 months.
  16. 16. Investor Rights for the 21st Century 3 An investor, even after checking with the NASD, should also call the state securities office of the state that the investor resides in. There are times when state regulators may disclose information that the NASD will not. 6) How can investors check the background of their financial planner or money manager? The first step, once again, is to check the CRD System. Even if the financial planner or money manager is not a licensed broker, some advisors are listed in the system. However, the most important step in checking their background is to review a copy of the adviser’s standard regulatory filing, known as Form ADV, which can be acquired from either the advisor, the investor’s state securities regulator, or the Securities and Exchange Commission (www.sec.gov). Advisers must provide investors with Part II of their ADV, which contains information about their compensation, experience and training. In Part II, examine questions 1C, 1D, 13A and Schedule F which will disclose any financial arrangements that could contaminate the adviser’s judgment and make her recommend one investment over another. For instance, check to see if the adviser receives compensation from a mutual fund company for recommending that family of funds. Other important information can be found in the answers to Item Seven of Schedule D which deals with financial planning credentials, Question Six, which asks for the adviser’s educational and business background and Question Eight which lists any business ties to insurers, broker-dealers or other businesses. Part I is also important to examine and will list any legal or regulatory problems. When reviewing the ADV, first examine Question 11 of Part I. A “yes” answer to any of the questions is a signal that the adviser has had regulatory or legal problems.
  17. 17. Maddox / Stoltmann 4 7) Does the Central Registration Depository accurately reflect all broker wrongdoings? No. The CRD is supposed to give investors an accurate look at a broker’s record and includes information such as disciplinary problems, customer complaints, bankruptcy and criminal records. Some information does not make it to the CRD because the broker or brokerage firm failed to file it or was not required to disclose it. There are times, however, when information should go onto a broker’s permanent record and it does not. For instance, a Wisconsin arbitration panel ordered a Wisconsin brokerage firm to pay $86,500 to a Milwaukee investor who filed a complaint alleging unsuitable investments, unauthorized trading and churning. The arbitration complaint accurately identified the broker by name, yet a full two years after the order, the information did not appear on the broker’s CRD. Even though investors and arbitrators can get detailed history on a broker’s background, there is no guarantee that all complaints and awards will be recorded. 8) What is the difference between a broker, an investment adviser and a financial planner? Brokers generally collect commissions based on the transaction while advisers and planners charge a flat advising fee or take a percentage of the investors’ assets under management for their services. However, today some brokers charge a percentage of assets while other planners may charge commissions. In essence, the investment functions of each can overlap with one another thereby blurring the distinction between the three. There is a much higher degree of overlap today than there was even ten years ago. Going forward, the line should blur even further. 9) Who regulates investment advisers and financial planners? Brokers must register with the NASD and be licensed by the states in which they do business. Financial planners, money managers and other advisers must be licensed as “investment advisers” by their states, or if they have $25 million or more under
  18. 18. Investor Rights for the 21st Century 5 management, by the SEC. Even accountants and lawyers who provide financial advice must be licensed as investment advisers by securities regulators, unless the advice is “incidental” to their main business. 10) Are most investment professionals unethical? No. Even though investment abuses are widespread, underreported and extremely costly to defrauded investors, many investment professionals are honest and do add a great deal in performance to their investor’s returns. Good stockbrokers, financial planners and money managers are extremely valuable. Financial planning is not like learning how to knit. It cannot be learned on the weekends. Like any profession, it is the minority of dishonest and unethical stockbrokers, insurance agents, financial planners and accountants that cause most of the problems and bad publicity. 11) What is the major reason for investment abuses? There are many reasons why investors get taken advantage of by their investment advisor. Probably the most common reason is greed on the part of the registered representative. Though the securities industry is attempting to move away from commission based transactions with investors, the vast majority of all securities transactions are still commission based. For instance, insurance agents and financial planners may receive commissions of up to 7 percent on annuities, which they share with their firm. Load based mutual funds pay only, on average, 4 percent to the registered rep. Selling stocks or bonds pay the representative only 1 percent. Therefore, the incentive in many instances is to sell a product that might not be suitable for the investor because the one who is making the recommendation gets paid more. 12) What is another cause for investment abuses? Unfortunately brokers and investment advisers prey and feed off of investors’ ignorance. An uninformed investor is generally less likely to ask questions because often he is too embarrassed to admit his lack of knowledge. For example, a survey done by the AARP in 1998 showed that 64 percent of those investors surveyed were unaware that brokerage
  19. 19. Maddox / Stoltmann 6 firms often pay higher commissions for the sale of riskier investments and 15 percent of those surveyed did not even know that they paid a commission or markup to buy or sell stocks, mutual funds or bonds. Those surveyed were investors who had used financial advisers and brokers in the past. A study from the Columbia University Graduate School of Business found that out of 3,300 mutual fund investors surveyed, 72 percent didn’t know if they were invested in domestic or international mutual funds and 75 percent didn’t know if they were invested in equity or fixed income funds. Unethical brokers, financial planners and insurance agents thrive off of ignorance and generally prefer that their clients stay uninformed. 13) What securities firms have had problems in the past? The question with a much shorter answer is which securities firms have not had problems. Most well known firms budget millions of dollars annually to pay their attorneys and damaged investors through arbitration awards. In the insurance field, one well-known company defrauded tens of thousands of investors and eventually was forced to pay investors $2 billion for the firm’s fraudulent sales practices. In the brokerage industry, a regional firm paid investors over $138 million due to losses that were incurred in a short term, government bond fund that plunged in value after a surge in interest rates battered the funds massive holdings in mortgage derivatives. By definition, the fund should have been one of the safest mutual funds in existence. In 1996, one of the largest brokerage firms in the nation agreed to pay $250 million, including a total of $45 million toward a restitution fund and civil penalty, to settle an SEC civil administrative complaint and related class action claims that some of its brokers misled investors in selling hundreds of millions of dollars in limited partnerships. In 1997, another well-known brokerage firm agreed to pay approximately $70 million to settle allegations that the firm’s dealers unfairly kept prices and profits in NASDAQ stocks unduly high between 1989 and 1994. Unfortunately, the list goes on and on.
  20. 20. Investor Rights for the 21st Century 7 14) Are discount brokerage firms immune from defrauding investors? Absolutely not. In 1998, a well known “full service discount firm” was fined over $5 million by the SEC for fraudulent sales practices. The firm’s brokers were found to have been pressured by management to sell particular stocks in the firm’s inventory where the brokers would receive a markup on the stocks from six cents a share to over a dollar a share, all the time the firm was advertising “commission free” trades. Many other discount brokerage firms now provide research reports, generate investment ideas for their clients, provide “unbiased” advice on mutual funds, provide 24 hour access to brokers over the phone, recommend certain industries to purchase stocks from and asset allocate the portfolios for the firm’s clients. One firm’s co-CEO rhetorically asked in a SmartMoney article in 1998 that if what his firm provides is not full service, then what is? These are the traditional functions that full service brokerage firms provide to their clients and therefore in many cases, the “discount” firms have the same stringent legal obligations as full service brokerage firms. 15) Are online investment firms immune from defrauding their clients? No. There are an increasing number of arbitration claims being filed against online brokerage firms. In 2000, 214 claims against online firms were filed, up from none in 1998. The authors’ law firm commenced an arbitration claim against one of the largest online brokerage firms alleging margin account and suitability abuses. The client, a 27 year-old graduate student with virtually no investment experience, lost more than $40,000 in savings for medical school by trading Internet stocks in his margin account. The online firm gave the investor no warning that a margin call was imminent and virtually no time to meet his margin call before they sold the investor out at a substantial loss. Fortunately, he was able to recover his losses. The market volatility in the spring of 2000 led to hundreds, if not thousands, of other unauthorized margin liquidations for clients of online firms.
  21. 21. Maddox / Stoltmann 8 In February of 2001, one of the nation’s largest online firm’s was fined $225,000 by the New York Stock Exchange Division of Enforcement for engaging in “conduct inconsistent with just and equitable principals of trade” including a failure to maintain appropriate procedures for supervision, maintaining inadequate telephone systems, allowing multiple non-exchange registered employees to engage in activities that required registration and failing to report, as required under the Exchange rules, over 18,000 complaints. As online trading continues to grow, arbitration complaints against e- brokers will continue to increase. 16) Are accountants immune from defrauding investors? No. Today, accountants sell investments and manage money just like full service brokers. A survey of accountants by the American Institute of CPAs concluded that 12 percent of their 329,000 members surveyed are already receiving fees and commissions relating to financial advisory services. At least 35 states have enacted legislation permitting accountants to receive commissions, which was once completely forbidden in the accounting industry. It is much more common today for investors to complain about abuses caused by the management of their portfolio by their accountants than even five years ago. 17) Are banks getting in on the investment business? Yes, and unfortunately many of the same abuses caused by full service firms are now occurring at banks. For example, in 1998, a well-known national bank agreed to pay $6.75 million in fines to settle federal charges that it misled mostly elderly investors by marketing volatile securities as safe banking products. An investor must take all of the same precautions when dealing with a bank as would be taken when dealing with a full service broker.
  22. 22. Investor Rights for the 21st Century 9 The Investment Products and their Abuses 18) Stocks The most common disputes in arbitration continue to involve individual stocks. Individual stock recommendations continue to be one of the broker’s favorite vehicles for defrauding investors. At the end of 1999, American households possessed over $5.4 trillion in individual stocks, which was second behind only the $7.4 trillion in pension funds. An individual stock purchased at a full service firm costs approximately 1 percent of the purchase price. While this may not seem to be a large amount, the commissions can pile up quickly if a broker trades frequently in the investor’s account. Investment abuses with individual stocks are well documented. However, in recent years, more complaints are surfacing dealing with initial public offerings or IPOs. It is common for brokers to make misrepresentations and false claims concerning IPOs. The temptation is great for brokers to “sell the sizzle” and make guarantees on returns and inaccurate price forecasts with IPOs because investors generally only hear about the highly successful IPOs like Microsoft and Apple and not the hundreds of poor performing IPOs. A study commissioned by the Midtown Research Group in New York showed that of 341 IPOs in 1997 that exceeded $20 million, 55 percent traded below their IPO price and 24 percent were down more than 50 percent at the time of the study. IPOs are typically unsuitable investments for many investors. Brokers will use an IPO to convince relatively conservative investors to start purchasing individual stocks. The IPO serves as a “lure” to convince investors to take more risk than the broker knows is appropriate. IPOs are often high-risk, speculative investments. There is never a guarantee that an IPO will open above the price that the investor paid. When coupled with the compensation that brokers usually receive from IPOs, which is typically greater than a traditional stock purchase, it is no surprise that brokers find IPOs so attractive to sell. Firms that bring many companies public will often use future IPO allocations as a recruiting tool when trying to hire brokers from other firms.
  23. 23. Maddox / Stoltmann 10 19) Bonds Bonds are one of the investments that are the least understood by investors. As a result, few other investments are as wrought with as many abuses as bonds. First, brokers typically do an awful job of disclosing the risks associated with bonds. Brokers sell bonds as a conservative investment, when in fact many times they are not. Government bond funds often load up on mortgage-backed bonds such as Ginnie Maes to increase their yields. While these bonds are backed by the government, they can still be very volatile due to changing interest rates. This is typically not disclosed to investors. Brokers also fail to tell investors that any bond, regardless of whether it is a government bond or an AAA rated bond, can lose money if it is not held to maturity. For example, a government bond purchased when interest rates are at five percent will plummet in value if interest rates subsequently rise to seven percent. If an investor sells her bond at that point, she will have a loss on the safest investment available. Another problem is that unlike stocks and mutual funds, bond prices are not readily discernable to most investors. In the usual principal transaction, a broker buys a bond at one price and sells it to the investor at a higher price and the broker and brokerage firm pocket the difference. When a broker buys a bond from an investor, they do the opposite, charging a “markdown.” Unfortunately, bonds do not trade on an exchange, meaning investors have little way of gauging the actual market price. The NASD only requires that bond markups be “fair.” Another problem investors need to be wary of is that brokers are often given financial incentives to push one bond over another. Brokers receiving extra compensation for selling certain products is a significant problem in the securities industry and is especially common for fixed income products. Brokers will push a bond from their firm’s inventory because they can make more in commissions. Instead of recommending a bond to a customer because it is suitable or the best fit for that investor’s portfolio, brokers are encouraged by their compensation system to recommend one bond over another because of the higher payout that the firm’s inventoried bonds provide. Unfortunately, brokers
  24. 24. Investor Rights for the 21st Century 11 usually receive more in compensation for selling lower quality bonds, which often takes precedence over suitability considerations. 20) Mutual Funds One of the major problems investors face with mutual funds is the high degree of switching between different funds. Mutual funds are one of the most popular investments that stockbrokers and financial planners sell to their clients in large part because the commissions are so high. For “A” shares, still the most frequently sold share type, the brokerage firm receives approximately 4 percent up-front on the purchase price for a load mutual fund and a “trailer” commission each year based on the amount of money in the fund. The “trailer” is usually a very small percentage of the assets in the fund averaging anywhere from approximately 5 basis points (1/20 of 1 percent) to 25 basis points (1/4 of 1 percent). Even though most mutual funds should be held for a minimum of five years, the average holding period for growth and value funds is under three years. Brokers are a big part of the problem. If a broker can convince a client to sell one mutual fund and purchase another one from a different family of funds, the broker can receive another 4 percent commission instead of the lesser yearly “trailer” commission. Brokers find it an easy sell to convince investors to liquidate a mutual fund that is not the current year’s hot fund. The high degree of switching is caused, in part, by brokers failing to distinguish between investment returns and investor returns. What many investors fail to realize is that there is a major difference between investment returns (what the mutual fund’s total return is from January 1st, to December 31st) versus investor return (what the investor who invests in that mutual fund actually receives as a total return). For example, from 1984 to 1995 the average stock mutual fund posted a yearly investment return of 12.3 percent. An impressive result especially when compared to the long-term returns for stocks. However, the average investor return over that same time frame was only 6.3 percent while the average investor in a bond mutual fund earned 8
  25. 25. Maddox / Stoltmann 12 percent. In other words, the average mutual fund bond investor did better than the average mutual fund stock investor during one of the greatest eleven year time periods in the history of the market! There are a number of reasons for this discrepancy between what the average mutual fund returns and what the average investor who invests in those mutual funds receive. One of the major causes, however, is that brokers and financial planners generally sell investors whatever the newest, hottest mutual fund that is currently being touted. Typically, by the time the investor gets into the fund, most of the gains have already been made. The broker then has an easy sell a year or two later when he touts the new, hot, popular mutual fund. The broker’s incentive is a large commission from the purchase of the new mutual fund coming on the heels of the previous load commission from a year or two back. 21) Margin Margin is an extremely popular tool brokers use to take advantage of investors. A margin account allows customers of the brokerage firm to buy securities with money borrowed from the firm. The customer pays an agreed upon interest rate to the brokerage firm for the right to borrow the money. The Federal Reserve requires that investors making their initial purchase of a stock must pay cash for no less than fifty percent of the price. This is known as a margin requirement. A margin call is a demand that an investor deposits enough money or securities to bring a margin account up to the minimum requirement. If the investor fails to respond, securities in the amount will usually be sold. One reason why margin accounts are so popular with brokers is because they give the client extra buying power. This extra buying power can be used to purchase more securities and therefore generate more commissions for the broker. One of the problems with margin accounts, though, is that many brokers are using margin for investors who are inexperienced or do not understand the risks involved with these accounts. Brokers fail to inform investors that the risks with margin accounts are extremely high. Often, the first time an investor learns about the risks inherent in a margin loan is after the investor
  26. 26. Investor Rights for the 21st Century 13 receives a margin call and extensive loses are sustained. Brokerage firms and brokers typically do not do an adequate job of disclosing the risks to investors before they take out a margin loan. Unfortunately, margin abuses increased dramatically in 2000 and 2001. In 1997, there were only 25 margin complaints filed with the NASD compared to 284 in 2000. Through March of 2001, the number of margin complaints was 98. If the trend continues through the rest of 2001, there will have been almost 400 margin complaints filed with the NASD, almost a 16-fold increase in only four years. 22) Annuities One of the major problems with annuities is that brokers have an extra incentive to sell variable and fixed annuities due to the high payouts that they provide. Annuities are typically sold, not bought. Insurance agents, stockbrokers and commission-paid financial planners can receive a payout of up to 7 percent on annuities, which they share with their firm. Very few investment products pay this well. Load based mutual funds pay only, on average, 4 percent to the registered rep. Selling stock or bonds pay the representative only 1 percent. Therefore, the incentive in many instances is to force a product that might not be suitable for the investor because the one who is making the recommendation gets paid more. A second problem with annuities from the investor’s perspective is that annuity expenses are often extremely high. Investors pay the traditional annual management fee just like they would with a traditional mutual fund. However, with annuities there is an extra layer of fees. In addition to the investment fee on the portfolio, there is a “mortality and expense risk” charge, typically 1 percent or more a year. In 1999, the expenses (the portfolio management fees plus the mortality charge) averaged a hefty 2.1 percent a year. That is double what it costs to manage the average mutual fund and ten times what it costs to manage the Vanguard Index 500 fund.
  27. 27. Maddox / Stoltmann 14 The best evidence of how attractive annuities are to financial representatives is that in 1998, approximately $21 billion of annuities sold went into IRAs. One of the major advantages of annuities that financial planners, brokers and insurance agents push is that annuities are mutual funds that allow for tax deferred growth. That is undoubtedly true. However, putting an annuity in an IRA is virtually useless. There is no legitimate reason to put a tax-deferred investment like an annuity into a tax-deferred account like an IRA because an investor is already getting the benefit of tax deferred growth via the annuity. 23) Options Not a great deal needs to be said about options. Though there are some option strategies that are conservative in nature, most options are inherently speculative and should only be used with a highly sophisticated, experienced investor. Most brokerage firms have relatively strict criterion for who can buy, sell and trade options. Options are usually not a suitable investment for most individual investors. 24) Fee Based Accounts Many brokerage firms are moving toward fee based compensation for their brokers which claim to align the broker’s interests along with those of the investor. With a fee based account, an investor is usually charged anywhere from half a percent (50 basis points) to three percent (300 basis points) annually. The investor then receives a substantial number of stock purchases and sales a year with no commission being charged on the individual stock transactions. Despite the grand claims made by the brokerage firms, often the fee-based account does not serve the intended purpose of what it was designed to do. Brokers infrequently place active investors (AKA profitable investors) into a wrap or fee based account. The fee- based account is often used to increase income from buy-and-hold investors. While a buy and hold strategy is usually the best option for an investor, that client does not generate much, if any, revenue for the broker. The solution for the broker and brokerage
  28. 28. Investor Rights for the 21st Century 15 firm? Put the investor into a fee-based account and charge the investor up to three percent annually. Often, there are other problems investors face with these accounts. For example, many fee accounts base the annual management fee off of the gross assets under management- including assets bought on margin. Therefore, brokers have an inherent incentive to use margin to increase the total account value, thereby increasing their fee. Assuming a one percent annual fee on a $100,000 account, a broker who utilizes margin for another $100,000 in the account can double his fee, regardless of the suitability of the margin. Equally problematic is that the management fee is not usually based on a rolling average of the assets under management but rather it is calculated based on the total assets in the account, as of a particular day at the end of the quarter. Therefore, if a broker buys stock on margin just prior to the date the fee is calculated, he gets a larger fee. Many times, there are other undisclosed commissions or markups a broker can receive for buying certain investments being recommended by the brokerage firm. The client usually has no idea of these extra fees. 25) What other investment products or scams do investors need to be wary of? The North American Securities Administrators Association annually releases their “Top 10 Investment Scams.” For 2001, they listed the following scams: 1. Unlicensed individuals, such as life insurance agents, selling securities. To verify that a person is licensed or registered to sell securities, call your state securities regulator. If the person is not registered, don’t invest. In Indiana, 11 of the 16 “cease and desist” orders issued by the Securities Division in the first quarter of this year have targeted insurance agents who were selling securities without the proper license. Most were independent life insurance agents. 2. Affinity group fraud. Many scammers use their victim’s religious or ethnic identity to
  29. 29. Maddox / Stoltmann 16 gain their trust – knowing that it’s human nature to trust people who are like you – and then steal their life savings. From “gifting” programs at some churches to foreign exchange scams targeted at Asian Americans, no group seems to be without con artists who seek to exploit others for financial gain. In Texas, an Indian immigrant who taught Sunday school took fellow Indian parishioners – roughly 40 families in all – for over $1 million. 3. Payphone and ATM sales. In early March of 2001, 25 states and the District of Columbia announced actions against companies and individuals – many of them independent life insurance agents – that took roughly 4,500 people for $76 million selling coin-operated customer-owned telephones. Investors leased payphones for between $5,000 and $7,000 and were promised annual returns of up to 15 percent. Regulators say the largest of these investments appeared to be nothing but Ponzi schemes. 4. Promissory notes. Short-term debt instruments issued by little-known or sometimes non-existent companies that promise high returns – upwards of 15 percent monthly – with little or no risk. These notes are often sold to investors by independent life insurance agents. In Indiana, 18 elderly investors lost some $1.4 million in a promissory note scam. An 80-year-old woman lost her life savings of $324,000. The perpetrators – who diverted the money to offshore bank accounts, made first-class business trips to China, India and Greece and bought expensive cars – even knelt in prayer with their victims to gain their trust. 5. Internet fraud. Scammers use the wide reach and supposed anonymity of the Internet to “pump and dump” thinly traded stocks, peddle bogus offshore “prime bank” investments and publicize pyramid schemes. Roughly half the states have Internet surveillance programs that watch for fraud or investigate investor complaints. 6. Ponzi/pyramid schemes. Always in style, these swindles promise high returns to investors, but the only people who consistently make money are the promoters who set them in motion, using money from previous investors to pay new investors. Inevitably,
  30. 30. Investor Rights for the 21st Century 17 the schemes collapse. Ponzi schemes are the legacy of Italian immigrant Charles Ponzi. In the early 1900s, he took investors for $10 million by promising 40 percent returns from arbitrage profits on International Postal Reply Coupons. 7. “Callable” CDs. These higher-yielding certificates of deposit won’t mature for 10- to 20 -years, unless the bank, not the investor, “calls,” or redeems, them. Redeeming the CD early may result in large losses – upwards of 25 percent of the original investment. In Iowa, for example, a retiree in her 70s invested over $100,000 of her 97-year-old mother’s money in three “callable” CDs with 20-year maturities. Her intention, she told her broker, was to use the money to pay her mother’s nursing home bills. Regulators say sellers of callable CDs often don’t adequately disclose the risks and restrictions. 8. Viatical settlements. Originated as a way to help the gravely ill pay their bills, these interests in the death benefits of terminally ill patients are always risky and sometimes fraudulent. The insured gets a percentage of the death benefit in cash, investors get a share of the death benefit when the insured dies. Because of uncertainties predicting when someone will die, these investments are extremely speculative. In a new twist, Pennsylvania regulators say “senior settlements” – interests in the death benefits of healthy older people – are now being offered to investors. 9. Prime bank schemes. Scammers promise investors triple-digit returns through access to the investment portfolios of the world’s elite banks. Purveyors of these schemes often target conspiracy theorists, promising access to the “secret” investments used by the Rothschilds or Saudi royalty. In North Dakota, state securities regulators are alleging a small group of salesmen, including a local pastor, used religion and family ties to bilk investors out of $2 million in a prime bank scam. 10. Investment seminars. Often the people getting rich are those running the seminar, making money from admission fees and the sale of books and audiotapes. These seminars are marketed through newspaper, radio and TV ads and “infomercials” on cable television.
  31. 31. Maddox / Stoltmann 18 The Most Common Types of Arbitration Complaints 26) What securities are involved in arbitrations? Securities arbitrations involve all different types of securities. However, certain securities appear in more arbitrations than others. In 2000, the most common security involved in arbitrations at the NASD were common stocks with 2,018 claims filed. The second most common security type in NASD arbitration in 2000 were options with 299 cases filed followed by mutual funds (261), corporate bonds (141) and limited partnerships (72). 27) How much compensation was awarded to customer Claimants at the NASD in 2000? In 2000, customer Claimants were awarded $76 million, which was comprised of $21 million in punitive damages and $55 million in non-punitive damages. In 1999, customer Claimants were awarded $126 million ($48 million in punitive damages and $78 million in non-punitive damages). The punitive damage number can be misleading, however, since a significant percentage of the punitive damages awarded were against defunct, bankrupt brokerage firms which makes collectibility almost impossible. Misrepresentations and Omissions 28) What is a misrepresentation or omission? A broker may be liable to a customer if the broker misrepresents material facts (lies) or fails to disclose material facts (leaves out important information) to the investor in the sale or recommendation of an investment. Usually, misrepresentations or omissions disguise the risk associated with a particular investment. The broker has a duty to fairly and accurately disclose all of the risks associated with an investment and not just the bullish, optimistic sale points.
  32. 32. Investor Rights for the 21st Century 19 29) How common are misrepresentations and omissions? In 2000, there were approximately 1,321 cases filed with the NASD alleging a broker misrepresented a material fact or failed to disclose material information to an investor. 30) What is an example of a misrepresentation or omission? Examples of an omission might be if a broker fails to disclose to an investor that the individual company he is recommending lost money in the previous three years or the brokerage firm is charging the customer an undisclosed commission or markup. If a broker told an investor that the stock being recommended had a new drug pending before the Food and Drug Administration and that was not the case, that would at a minimum be a misrepresentation. Breach of Fiduciary Duties 31) Is a stockbroker a fiduciary for the customer? In many cases, yes. In the past, some courts and arbitrators have said there is always a fiduciary relationship between the investor and broker. A broker is generally considered the agent of a customer. As a customer’s agent, the broker owes certain duties to the customer. The level of duty that is owed to the customer can only be determined by evaluating the entire relationship between the broker and the investor. In many circumstances, the duty between a broker and his customer is considered to be a fiduciary duty. 32) How common is it for a broker to breach his or her fiduciary duties to the customer? Unfortunately, it is very common. In 2000, a broker breaching a fiduciary duty was the most common type of abuse perpetrated against investors with 2,489 complaints filed with the NASD.
  33. 33. Maddox / Stoltmann 20 33) How do arbitrators decide whether there is a fiduciary relationship or not? To determine the duty of a broker to his customer, arbitrators may evaluate the following factors, just to name a few: a) the sophistication of the investor; b) the customer’s prior investment experience; c) the representations of the broker; d) the ability of the customer to verify the broker’s representations; and/or e) degree of faith the investor places in the broker. 34) What is the result when a broker is classified as a fiduciary? When a fiduciary relationship exists between a broker and his client, the broker automatically owes his client a very high standard of care and therefore must unequivocally act in the best interests of the investor. The broker owes the client the highest possible duty of care and loyalty. A deviation from these obligations would result in almost automatic liability against the broker. However, regardless of whether there is or is not a fiduciary relationship, at the very least, the broker has an obligation to act in good faith, and with honesty and integrity. Suitability 35) What is an unsuitable recommendation? An unsuitable recommendation is one which, in light of the investor’s objectives and background, the broker knows or should know is inappropriate. For instance, if a broker recommends to a 65 year-old investor to short sell a technology stock when the broker knows the investor’s investment objective is current income or long-term growth, then the broker will have made an unsuitable investment recommendation.
  34. 34. Investor Rights for the 21st Century 21 36) How common are suitability claims? In 2000, there were 900 cases filed against brokers at the NASD alleging unsuitable investment recommendations. A survey done by Prophet Market Research & Consulting in 1996 helps illustrate how wide spread the problem is of brokers and financial planners making unsuitable investment recommendations. The research company surveyed the sales practices of 21 of the nation’s largest full service brokerage firms using 93 “mystery shoppers” presenting themselves as unsophisticated, first time investors. The survey found that brokers handed out specific investment advice to more than half of the mystery shoppers without asking even the most basic questions about their finances, such as their tax bracket or income level. Incredibly, almost half of the shoppers were recommended stock mutual funds and nearly a quarter were pitched individual stocks without the broker profiling the investor. A broker cannot make a suitable recommendation without finding out detailed information such as the investor’s tax bracket, income level, investment objectives and risk tolerance level. Unfortunately, the Prophet survey confirms what occurs on a regular basis: brokers and financial planners do not adequately profile their clients and this in effect makes it nearly impossible for many brokers to make suitable investment recommendations. 37) Why would a broker make an unsuitable recommendation? Extra compensation is one very common reason. Brokers make varying amounts of compensation depending on the type of security sold to the investor. For example, a broker can make considerably more in commissions by selling lower priced stocks, unit investment trusts, limited partnerships, options, new issues and in house mutual funds than by purchasing conservative certificate of deposits, T-bills or money market funds. The broker therefore has a built in incentive to sell speculative investments, regardless of suitability considerations, than more conservative (and often more suitable) securities. The mentality of many stockbrokers is to try to fit a square peg in a round hole rather than making an individualized determination based off of the facts and circumstances of
  35. 35. Maddox / Stoltmann 22 that individual investor. Often, brokers use compensation as the primary means for determining suitability. 38) What is the NASD Suitability rule? NASD Conduct Rule 2310 mandates that: a) “In recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and his financial situation and needs.” b) “Prior to the execution of a transaction recommended to a non-institutional customer…a member shall make reasonable efforts to obtain information concerning: (1) the customer’s financial status; (2) the customer’s tax status; (3) the customer’s investment objectives; and (4) such other information used or considered to be reasonable by such a member or registered representative in making recommendations to the customer.” 39) What is the New York Stock Exchange “Know Your Customer” rule? NYSE Rule 405 mandates that “Every member organization is required…to use due diligence to learn the essential facts relative to every customer, every order, every cash or margin account accepted or carried by such organization…” 40) Is there a difference between the NASD’s Suitability rule and the NYSE’s “Know Your Customer” rule? Yes. An important difference between the NASD and NYSE rules outlined above is that there is arguably a question as to whether the NASD suitability rule is only applicable
  36. 36. Investor Rights for the 21st Century 23 when a broker recommends an investment while NYSE Rule 405 applies anytime any investor makes any type of transaction with a brokerage firm, regardless of who recommended it. The NYSE essentially requires its members to ensure that an investment is suited to a client’s needs and circumstances before making the sale, even if the transaction was the investor’s idea. In comparison, if a customer trading through an NASD firm buys a stock that has not been recommended by the broker, the firm arguably is not under an obligation to evaluate whether the investment is appropriate (or at least it is not as clear cut). As online trading continues to grow, this distinction becomes more important. A customer of an NASD deep discount e-broker member firm who trades his way into huge losses from an inappropriately risky investment might have a hard time recovering on suitability grounds (clouding the issue tremendously, however, is the fact that many online firms like E*Trade, Charles Schwab and Ameritrade offer research reports and other services that do make specific recommendations.) However, a customer at a NYSE member firm will have an easier chance to recover his or her losses due to NYSE Rule 405. NYSE member firms have an obligation to, as the Rule states, “use due diligence to learn the essential facts relative to every customer, every order, every cash or margin account accepted or carried by such organization…” Simply because the firm does not recommend an investment or transaction does not shield them from liability. The online firm cannot escape liability by saying “it was the customer who wanted to do the trade and therefore our hands are free.” 41) Should the same suitability standards that apply to traditional full service brokers also apply to online brokerage firms? Yes. Day/short-term trading at online brokerage firms threatens billions of dollars in the retirement and brokerage accounts of this nation’s small, inexperienced individual
  37. 37. Maddox / Stoltmann 24 investors. In order to protect the least experienced investors, the NASD needs to clearly extend the suitability rules that full service brokerage firms face to the online firms. The growth of online trading is well documented. At the end of 1999 there were approximately 7.5 million online trading accounts nationwide. By the end of 2000, that number was expected to swell to 10.5 million according to Concord, Mass.-based Gomez Advisors. By 2002, the number is expected to reach 18 million. Online firms actively promote themselves as a substitute for full service brokerage firms. Yet they try to hide behind their standing as an online firm to claim they have no obligations for their investor’s actions. Since many online brokerage firms are positioning themselves as a type of less expensive, full service firm, they must also be forced to abide by the same suitability standards as full service firms. Online firms offer what looks like the same detailed research that the full service firms provide to their customers. E*Trade customers have access to work from BancBoston Robertson Stephens. Investors who use Fidelity.com now can get research from Salomon Smith Barney Inc. Discover Brokerage Direct investors have access to Morgan Stanley Dean Witter & Co. stock picks. And investors who use Charles Schwab Corp.'s Schwab.com can choose research from either Credit Suisse First Boston Inc. or Hambrecht & Quist Group. Almost all of the major online firms also provide financial planning tools on their website that permit customers to specify certain criteria and then, based on those criterion, presents customers with investment alternatives. Most online firms provide research dealing with particular companies and their securities. Many e-brokers have links from their websites to external sites that reference and address particular pre-chosen securities. When online brokerage firms provide research reports, generate investment ideas for their clients, provide chat rooms that allow investors to discuss investment ideas and send out price and news alerts on individual companies these activities can only be viewed as an
  38. 38. Investor Rights for the 21st Century 25 implicit sales solicitation and an encouragement to trade. The technology offered by these firms is extremely enticing to novice and inexperienced investors. Equally important is that online firms actively promote themselves through their advertising and marketing as a substitute for full service firms while at the same time downplaying the risks of day/short-term trading. Charles Schwab’s new advertising campaign pushes the firm as a “full-service electronic investing” firm even though Schwab made its name as a discount broker. Discover Brokerage Direct runs an ad featuring a tow truck driver shocking his towing customer with claims of his online day trading profits and the purchase of his own island-in reality, the driver says, it is a country. Online brokerage firms must be required to make a threshold determination that the investor's strategy is appropriate for that investor. Online firms must be required to first determine if a day trading strategy is suitable or too risky for particular investors. The state does not allow a person to have a driver license without a showing of competence in driving. Nor should online brokerage firms be able to look the other way when an inexperienced investor with limited investment assets is looking to commit financial suicide by engaging in a high-risk day trading strategy. During the account opening stage, the e-brokerage firm should be required to tell the investor that his or her account will be monitored for unusual activity and to present the customer with a “pick list” of activities that will be monitored, such as: frequency of trading, efforts to liquidate more than a specified percentage of account assets and purchases and sales that exceed a certain amount of money. If the investor's trading activity runs counter to the initially stated customer investment goals and financial situation, then the online firm must be compelled to intervene.
  39. 39. Maddox / Stoltmann 26 42) What is the NASD’s position on online suitability obligations for e-brokers? In March of 2001, the NASD released Notice To Members 01-23 (NTM 01-23) which addressed, for the first time, the suitability obligations of online brokerage firms. Specifically, NASD NTM 01-23, while disclosing "whether a particular transaction is in fact recommended depends on an analysis of all the relevant facts and circumstances," reasoned that a key factor in determining when online suitability obligations are triggered is whether a "communication from a broker/dealer to a customer reasonably would be viewed as a 'call to action,' or suggestion that the customer engage in a securities transaction." NTM 01-23 concluded "[T]he more individually tailored the communication to a specific customer or a targeted group of customers about a security or group of securities, the greater the likelihood that the communication may be viewed as a 'recommendation.'" NTM 01-23 considers the following scenarios to be recommendations, with the suitability obligations therefore attaching: -a firm provides a portfolio tool that allows a customer to indicate an investment goal and input personalized information such as age, financial condition and risk; -a firm sends a customer specific electronic communications i.e. an email or pop- up screen; -a member sends a customer an email stating that the customer should be invested in stocks from a particular sector. While NTM 01-23 is a good first step by the NASD, it clearly does not go far enough. Online firms should have the obligation to monitor all accounts at their firm to ensure the trading is consistent with the investment objectives listed on the new account application. For example, if a 65 year-old online investor discloses when opening an account that her objectives are conservative income and immediately engages in a high risk strategy of
  40. 40. Investor Rights for the 21st Century 27 shorting technology stocks, online firms should have the obligation, at a minimum, to contact that investor to inquire why there is such a dramatic discrepancy between her listed investment objectives and actual investment purchases. While online firms would likely argue this is too paternalistic an obligation, when dealing with investors’ life savings and retirement funds, online firms should have the threshold responsibility to ensure the investments are suitable since the result of an unsuitable investment strategy is many times financial devastation. The obligation is even greater when it is discovered that many online firms target less experienced investors who are typically the most likely to be swayed by the frequent barrage of encouragement by online firms to actively trade. Failure to Supervise 43) Does a branch manager or brokerage firm have an obligation to supervise the financial professionals working for the firm? Yes. Brokerage firms and their managers have an absolute obligation to supervise their employees and attempt to prevent securities violations. NASD Conduct Rules require brokerage firms to establish and enforce written procedures for supervising the activities of registered representatives, reviewing customer accounts and keeping records. Failure to reasonably do so will make the brokerage firm liable. NASD Conduct Rule 3010 outlines the brokerage firm’s obligation to supervise. Specifically, 3010 requires: (a) Supervisory System Each member shall establish and maintain a system to supervise the activities of each registered representative and associated person that is reasonably designed to achieve compliance with applicable securities laws and regulations, and with the Rules of this Association. Final responsibility for proper supervision shall rest with the member. (b) Written Procedures Each member shall establish, maintain, and enforce written procedures to supervise the types of business in which it engages and to supervise the activities of registered
  41. 41. Maddox / Stoltmann 28 representatives and associated persons that are reasonably designed to achieve compliance with applicable securities laws and regulations, and with the applicable Rules of this Association. (c) Internal Inspections Each member shall conduct a review, at least annually, of the businesses in which it engages, which review shall be reasonably designed to assist in detecting and preventing violations of and achieving compliance with applicable securities laws and regulations, and with the Rules of this Association. Each member shall review the activities of each office, which shall include the periodic examination of customer accounts to detect and prevent irregularities or abuses and at least an annual inspection of each office of supervisory jurisdiction. Each branch office of the member shall be inspected according to a cycle which shall be set forth in the firm’s written supervisory and inspection procedures. In establishing such cycle, the firm shall give consideration to the nature and complexity of the securities activities for which the location is responsible, the volume of business done, and the number of associated persons assigned to the location. Each member shall retain a written record of the dates upon which each review and inspection is conducted. 44) How common are claims for failure to supervise? In 1998, failure to supervise claims were the fourth most common type of abuse alleged by investors with approximately 1,270 claims filed with the NASD. Unauthorized Trading 45) When does unauthorized trading occur? Unauthorized trading occurs when a broker makes a trade in a client’s account without having either written or oral authority to do so. Brokers need to get their client’s explicit authorization before each and every trade unless it is a discretionary account. Failure to do so makes the broker liable for engaging in an unauthorized transaction.
  42. 42. Investor Rights for the 21st Century 29 46) How common are unauthorized trading abuses? Investors filed approximately 611 unauthorized trading claims with the NASD against financial professionals in 2000. 47) What is a discretionary account? A discretionary account is a type of brokerage account where the broker gets permission from the client, upfront, to place trades in the investor’s account without the client’s approval. Therefore, a broker does not need to speak with a client before placing a trade. If the broker does have written discretionary power, then the investor cannot make a successful unauthorized trading claim. Almost all brokerage firms have very specific, detailed procedures a customer must go through to grant a broker discretionary authority over his account. In recent years, most major brokerage firms have implemented an absolute prohibition on any type of discretionary trading due to the inherent temptations a broker faces with this type of authority. It is not hard to imagine brokers abusing their authority in managing discretionary accounts. Negligence 48) What is negligence with respect to a broker customer relationship? Negligence is conduct that falls below the “legal standard” established to protect others against unreasonable risk of harm. For example, a brokerage firm that sends out monthly statements with an inaccurate account balance will have engaged in negligent conduct, at a minimum. For an act to be negligent, the broker did not need to intend the consequence of his conduct, but a “reasonable person” in his position would have anticipated those consequences and taken reasonable precautions to guard against them. The standard of
  43. 43. Maddox / Stoltmann 30 care that a broker owes his client is at least “reasonable care.” It is left up to the arbitrators to determine what is “reasonable.” However, arbitrators many times apply a common sense evaluation to these cases. 49) How common are negligence claims against a broker? 1,936 negligence claims were filed against brokers with the NASD in 2000, making it the second most common type of abuse. Churning 50) What is churning? Churning occurs when a broker overtrades the securities in a customer’s account for the purpose of generating commissions. Churning is a synonym for over-trading where the stockbroker advances his or her interests over the interests of the client. 51) How common is churning? In 2000, there were approximately 473 cases filed at the NASD alleging a broker churned an investor’s account. 52) When does churning occur? One definition states that churning occurs when a broker, exercising control over the volume and frequency of trading, abuses his customer’s confidence for personal gain by initiating transactions that are excessive in view of the character of the account. Some of the traditional “trademarks” of churning are high turnover, frequent in and out trading, and large commissions. 53) Why would a stockbroker churn the investor’s account? The reason has to do with the broker being able to make more in commissions. Most stockbrokers are still paid on a commission-based system. What this means is that a
  44. 44. Investor Rights for the 21st Century 31 broker makes a commission for each buy or sell that occurs in a client’s account. The commission percentage is usually between one and three percent of the total transaction size. Therefore, if a broker can trade a client’s account more frequently, that means the broker will make more in “gross” commissions (brokers usually keep approximately one- third to one-half of their gross commissions) and therefore make more in take home pay. 54) What elements must be proven in an arbitration to establish churning? Three basic elements need to be established to prove the investor’s account has been churned. First, it must be established that the broker had control over the account. Second, trading in the account must have been excessive in light of the customer’s investment objectives. Finally, the broker must have intended to defraud the customer or had willful or reckless disregard of the customer’s interests. Most courts will simply imply the third element if the other two were established. 55) What are the different types of control a broker can have over an investor’s account. There are two types of control that a broker can have over an account. The first type is discretionary control. Discretionary control is where the customer gives the broker discretion as to the purchase and sale of securities, including selection, timing and price to be paid or received. The second and most common type is implied control. 56) How is implied control over an investor’s account established? Whether or not the customer has sufficient intelligence, understanding and market experience to evaluate the broker’s recommendation are sometimes important considerations in establishing implied control. Some of the other factors arbitrators may use to evaluate implied control are: a) the identity, age, education, intelligence, and investment and business experience of the customer;
  45. 45. Maddox / Stoltmann 32 b) the relationship between the customer and the broker, that is, whether it is an arms length one or a particularly close relationship; c) knowledge of the market and the account; d) the regularity of discussions between the account executive and the customer; e) whether the customer actually authorized each trade; f) who made the recommendations for trades; and g) investor’s reliance on other investment advisors for advice. 57) How important is the investor’s education level or profession in churning claims? While these can be important factors, they are by no means the most important factors arbitrators consider. There is a significant difference between success in life or success in a field like medicine, law or business and a person’s investment sophistication. Some of the most ignorant investors are those who have reached the pinnacle in their respective career. Sir Isaac Newton, widely considered to be one of the smartest individuals ever, lost his fortune in a stock market scam. Often, people hire a stockbroker or financial planner because they lack the knowledge in investing or do not have the time to monitor their investments. That is why they are hiring someone else to manage their money. Unfortunately, often this hands off approach is too big a temptation for a broker, financial planner or insurance agent. Many times the result is a churned account. 58) How is excessive activity determined? One definition of excessive activity is outlined in Hecht v. Harris, Uphan & Co. where the Court defined it as “whether the volume and frequency of transactions, considered in light of the nature of the account and the situation, needs and objectives of the customer, have been so ‘excessive’ as to indicate a purpose of the broker to derive profit for himself while disregarding the interests of the customer.”
  46. 46. Investor Rights for the 21st Century 33 The three most common real world methods for determining excessive trading are the turnover rate, the cost equity ratio and an in-and-out trading analysis. 59) What is a turnover rate? The turnover rate is the number of times the average net equity is used to purchase securities. The rate measures volume rather than cost. The formula for determining the turnover rate is the dollar amount of purchases divided by the average net equity divided by the amount of time. Turnover = Purchases Divided by Days in Period Average Equity 365 For example, say an investor had $100,000 of purchases in a one-year period and the average net equity is $20,000. We arrive at a turnover rate of 5 by dividing the total purchases of $100,000, by the average net equity of $20,000. We would then divide that number by the length of time that the investment was held. 60) What turnover rate establishes churning? Some case law sets forth the following rules of thumb: Turnover Rate Excessiveness 2x An inference of excessiveness 4x A presumption of excessiveness 6x A conclusion of excessiveness It seems in the last decade the collective thought has moved to the belief that an excessive turnover rate is now lower than what it was before. A well-regarded North Carolina Law Review article entitled “A Model for Determining the Excessive Trading Element in Churning Claims” by David Winslow and Seth Anderson convincingly argued that point concluding that much lower turnover ratios constitute churning than what has been accepted in the past. The article argued that using mutual funds as an appropriate proxy
  47. 47. Maddox / Stoltmann 34 would lead to the conclusion that a turnover rate in excess of three for any account would be evidence of churning. The article explicitly stated that courts should lower their threshold levels of the optimum turnover rates in investor’s accounts. 61) What is the cost equity ratio? The cost equity ratio, created in 1978 by longtime PIABA member and founder Stuart Goldberg, is used to determine the percentage of return on the client’s average net equity needed in order to pay the broker’s commissions. The cost equity ratio is computed by dividing the costs of the transactions divided by the average net equity. For instance, say a customer has a $100,000 equity account and the broker’s commissions off of the account for the year were $35,000. The cost equity ratio would be 35 percent. What this means is that the customer would have to earn a rate of return of 35 percent just to meet the expenses of the account. Considering the historical rate of return of the stock market is between 10 percent to 12 percent annually (according to Ibbotson Associates), it is easy to see why this so clearly would be considered problematic for a broker who recommended such a strategy. 62) What cost equity ratio establishes churning? Many commentators believe the following analysis should be utilized to evaluate if churning occurred: Cost Equity Ratio Excessiveness 2% An inference of excessiveness 4% A presumption of excessiveness 6% A conclusion of excessiveness It is not difficult to understand why even a two percent cost equity ratio would lead to an inference of churning. If one assumes the historical rate of return for the market is between 10 percent to 12 percent annually, trading that generates commissions of two percent means between 16 percent to 20 percent of an investor’s return (assuming the
  48. 48. Investor Rights for the 21st Century 35 historical return) is going towards paying a stockbroker’s commissions. That is simply too much. 63) What is in-and-out trading? In-and-out trading occurs when the stockbroker purchases a security, resells it after a relatively short duration, and then uses the proceeds from the sale to purchase another security that is of the same general type. For example, if 1,000 shares of XYZ preferred stock is bought on August 15th and sold four weeks later on September 15th , and then the broker purchases 1000 shares of ABC preferred stock, the original two transactions could be the subject of in-and-out trading within a one month period. 64) How does an investor establish excessiveness through the three methods? Arbitrators usually want expert testimony and statistical data to establish “excessiveness.” While expert testimony isn’t required, an investor would be well served to have an expert testify as to this element. 65) How is the final element of churning, an intent to defraud the customer or reckless disregard of the customer’s interests, established? Most courts simply imply the third element if the other two elements are established. Since churning involves a conflict where the broker seeks to maximize his pay in disregard of the customer’s interests, intent tends to be obvious and therefore implied. 66) Does a profitable account preclude an investor from prevailing on a churning claim? No. Profitability does not preclude a claim for churning. In the bull markets of 1982- 1987 and the 1990’s, a generally rising market masked a great deal of churning. The churning that took place in the investor’s account may have had the effect of decreasing the overall profit due to the sale of the original portfolio which might at the time of the
  49. 49. Maddox / Stoltmann 36 filing of the statement of claim have had a market value, if left undisturbed, in considerable excess of the newly acquired securities. 67) Is there a difference between churning and excessive trading? Yes. Arbitrators can find that an account was not churned but excessively traded. For instance, take the investor who had $75,000 worth of purchases in a one-year period and the average net equity was $50,000. We have a turnover ratio of 1.5, which is below an inference of churning. However, if the investor was 65 years old and told the broker he only wanted to buy and hold municipal bonds, then the arbitration panel could find that the broker was liable for excessive trading, but not churning, and still award the investor damages. 68) What are the odds of a stockbroker being able to successfully trade an investor’s account over any extended period of time? Between slim and none. The overwhelming majority of evidence leads one to conclude that an actively traded account by a stockbroker leads to substantial fees and commissions for the broker, almost certain underperformance relative to the S&P 500 Index by the investor and a dramatically increased absorption of risk for the investor in receiving these meager returns. Paul Samuelson, a highly respected U.S. economist, summarized it best when he stated: “A respect for evidence compels me to the hypothesis that most portfolio managers should go out of business.” Replace “portfolio manager” with “stockbroker” and the truth of his statement is still accurate when it comes to market timing efforts. Successful short term trading by a stockbroker is almost impossible. Virtually every piece of credible evidence points to the principal that the more an investor’s account is traded, the more likely the investor is to under-perform the market. Brad Barber and Terrance Odean, two professors at the University of California at Berkley, commissioned the study “The Common Stock Investment Performance of Individual Investors.” The study examined 60,000 accounts at a large discount brokerage firm (believed to be
  50. 50. Investor Rights for the 21st Century 37 Charles Schwab) between 1991 and 1996. The study concluded that the most active accounts in terms of trading also had the lowest investment returns. The correlation between trading and performance was clearly established as being positive-the more trades in an investor’s account the lower the investment returns. The authors concluded by noting “trading is hazardous to your wealth.” The virtual impossibility of a stockbroker successfully engaging in a short term trading strategy for clients relative to the performance of the S&P 500 Index is further shown in an analysis from University of Michigan Business School Finance Professor Najet Seyhun in a study entitled “Stock Market Extremes and Portfolio Performance.” This fascinating study found that the stock market does not rise or fall steadily but rather lurches dramatically over very short intervals of time. Unfortunately for stockbrokers who believe they can time the market through trading, these movements are extremely difficult to anticipate since they happen over such short periods of time. The study found that over a 30-year period (1963 to 1993), 95 percent of the stock market gains stemmed from only 1.2 percent of the trading days. Stated another way, if a stockbroker missed the best 1.2 percent of the trading days for his client, the investor missed out on 95 percent of the stock market’s return. The study also found that over a 67-year period (1926 through 1993) more than 99% of the total return of the market was "earned" during only 5.9 percent of the months. A clear example of this phenomenon occurred in April of 2001. From March of 2000 through March of 2001, the NASDAQ declined approximately 70 percent from its peak. However, in April of 2001, in only 10 trading sessions, the NASDAQ soared 33 percent. Unfortunately, many investors missed this dramatic rebound because their stockbroker had them sitting on the sidelines, out of the market, waiting for signs that the market had “bottomed out.” Unfortunately for the customer whose account is actively traded, the only way a stockbroker can successfully identify when those top 1.2 percent of the trading days will occur is through a crystal ball and the mythical 20-20 hindsight. Nobody knows when it is that the best days in the market will occur. If a broker is trading a client in and out of securities, it is highly probable that the investor will miss out
  51. 51. Maddox / Stoltmann 38 on the top performing days and therefore miss out on most of the market returns. Unfortunately, stockbrokers will still earn their commissions, regardless of their investor’s performance. Further demonstrating the negligence involved with a stockbroker trying to engage in a successful short term trading strategy is the concept in academic finance called skewness. The concept is based off of the premise that a stock index’s return in any year is extremely narrow and concentrated in only a few stocks. In most indexes (i.e. the S&P 500, NASDAQ or Russell 2000), it is typically only a few stocks (i.e. 5-10 stocks) that will make up a majority of that index’s return. The concept of skewness is based on the simple mathematical principal that the most a stock can decrease in any year is 100 percent but the most a stock can appreciate is unlimited. Therefore, investors need to cast a wide “net” (typically through a mutual fund) through a buy and hold strategy in order to own those unpredictable, small number of stocks that are needed in order to propel an investor’s investment return. A broker’s attempt to identify those five to ten stocks in an index like the Russell 2000, for example, is extremely difficult to do. Short term trading makes it even more likely that an investor will not enjoy the full appreciation in one of the few “highflying” stocks since they will not be held long enough to enjoy the full and complete run. Assuming, hypothetically, that a stockbroker could accurately time the market and successfully identify stocks that would appreciate in the short term, the costs to the investor in engaging in this type of strategy would serve as such a substantial drag on the investor’s return, the account would still likely under perform the market. As noted in the Wall Street Journal in 1998 by John “Launny” Steffens, Merrill Lynch’s former Vice Chairman who was responsible for managing the firm’s 14,000 stockbrokers, “[I]f people turn their account over two to three times a year, they are guaranteed not to make money.” There are multiple costs associated with active stock trading. The first cost incurred by an actively traded account is commission charges. Commissions typically range between

×