Investor rights for the 21st century

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

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.

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 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.

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

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

! 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

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

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

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

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

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

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

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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.

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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.

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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.

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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

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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

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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.

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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.

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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.

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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.

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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

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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

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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

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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.

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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

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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

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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,

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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.

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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.

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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.

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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.

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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

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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

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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

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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

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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.

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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

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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

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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.

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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

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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

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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;

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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.”

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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

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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

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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

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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

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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

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

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