Consumer Protection

FINRA Declines Rule Requiring Brokerage Firms To Carry Insurance

November 5, 2014 | by Staff Attorney

According to a recent report, the Financial Industry Regulatory Authority (FINRA) has decided it cannot force firms to carry insurance for payment of awards granted by arbitration panels on behalf of investors who have lost money.

As a background, every investor who opens a brokerage account with an investment firm agrees to arbitrate their dispute before the FINRA. Even if an investor did not open an account with a brokerage firm the claim can still be arbitrated under the industries rules. FINRA is the investment industries self-regulatory organization for all brokerage firms operating in the United States, overseeing approximately 4,700 brokerage firms and 635,000 registered representatives. FINRA both enforces its own rules through regulatory actions and administers an arbitration forum for securities disputes.

Our firm has noticed a recent trend where small and even mid-sized firms fail to keep sufficient funds on hand to pay investors due to misconduct at the firm. These smaller firms sometimes fail to enact proper supervisory procedures and regulatory controls to prevent their brokers from engaging in wrongful conduct. Sometimes these firms simply do not have the resources to properly engage in the securities business lines they attempt to engage in. As a result investors are harmed and due to their small size, cannot be compensated. In 2012, brokerage firms failed to pay $50 million in awards to customers. In 2011, the number of unpaid awards totaled $51 million.

SEC Cracks Down on Wrap Accounts to Prevent “Reverse Churning”

October 6, 2014 | by Staff Attorney

A recent InvestmentNews article explored The Securities and Exchange Commission’s (SEC) attempts to prevent conflicts of interest at registered investment advisers, a breach of their fiduciary duties, by focusing on potential misuse of popular flat-fee wrap accounts. The use of these accounts have given rise to claims of “reverse churning.” As we previously reported, “churning” is excessive trading activity or in a brokerage account. Churning trading activity has no utility for the investor and is conducted solely to generate commissions for the broker. By contrast “reverse churning” is the practice of placing investors in advisory accounts or wrap programs that pay a fixed fee, such as 1-2% annually, but generate little or no activity to justify that fee. Such programs constitute a form of commission and fee “double-dipping” in order to collect additional fees.

The SEC is looking into the practice by which clients pay an annual or quarterly fee for wrap products that manage a portfolio of investments. Investment advisors who place clients in such programs already charge fees based on assets under management (AUM) and the money management charges for wrap products are in addition to the AUM fee. According to InvestmentNews, the assets under these arrangements totaled $3.5 trillion in 2013, a 25% increase from 2012. Included in these numbers include separately managed accounts, mutual fund advisory programs, exchange-traded-fund (ETF) advisory programs, unified managed accounts, and two types of brokerage-based managed accounts.

Reverse churning can occur under these arrangements if there’s too little trading in the accounts in order to justify the high fees. In August, the SEC’s scrutiny of these products came to the forefront with the agency’s victory in a court case that revolved in part around an adviser’s improperly placing his clients into wrap programs. A jury decided in the SEC’s favor against the advisory firm Benjamin Lee Grant that the SEC argued improperly induced clients to follow him when he left the broker-dealer Wedbush Morgan Securities to his advisory firm, Sage Advisory Group.

Regulators On the Look Out for “Reverse Churning”

October 4, 2014 | by Staff Attorney

It is relatively easy to grasp the concept of excessive trading activity or “churning” in a brokerage account. Churning trading activity has no utility for the investor and is conducted solely to generate commissions for the broker. Churning involves both excessive purchases and sales of securities and the advisors control over the account. But regulators are also looking at another growing trend referred to as “reverse churning.” According to the Wall Street Journal (WSJ) the Securities and Exchange Commission (SEC) states that “reverse churning” is the practice of placing investors in advisory accounts that pay a fixed fee, such as 1-2% annually, but generate little or no activity to justify that fee. Regulators are watching for signs of “double-dipping” whereby advisers generate significant commissions in an investor’s brokerage account and then moves the client into an advisory account in order to collect additional fees.

As a background there are many standalone brokerage firms and investment advisor firms where the option does not exist for a client to be switched between types of accounts. However, there are also many dually registered firms which are both broker-dealers and investment advisers. These firms, and their financial advisors have tremendous influence over whether a customer establishes a brokerage or investment advisory account. In the WSJ, the SEC was quoted as saying that “This influence may create a risk that customers are placed in an inappropriate account type that increases revenue to the firm and may not provide a corresponding benefit to the customer.”

However, dumping a client account into an advisory account after the broker ceases trading is only one strategy that should be included in the category of “reverse churning.” There are many other creative ways that brokers can generate excessive commissions for themselves while providing no benefit to their clients. For example, if a broker recommends a tax deferred vehicle, such a as a variable annuity, in an IRA account there is no additional tax benefit for the client. While the recommendation would not result in excessive trading, the broker would earn a huge commission for an investment that cannot take advantage of one of its primary selling points.

SEC Releases Alert Warning Investors About Affinity Fraud

August 21, 2014 | by Staff Attorney

The SEC’s Office of Investor Education and Advocacy issued a Investor Alert to help educate and warn investors about the dangers of affinity fraud. Affinity fraud is a common type of securities fraud that preys upon members of a group or community such as members of certain religions or ethnic communities. Affinity frauds involve either fake investments or extremely risky investments that are conducted outside regular securities channels. The fraudster will typically lie about important details such as the risk of loss, the track record of the investment, or the background of the investment.

Many affinity frauds turn out to be Ponzi schemes. In a Ponzi scheme new investors money goes to pay earlier investors to create the illusion that the investment is succeeding all the while the fraudster skims large amounts of the funds for his or her personal use. When the fraudster’s supply of new investor money runs out and current investors seek payment the scheme collapses. Fraudsters use many legitimate investment sounding vehicles and names to mask their schemes. For example, the fraudster may tell investors that they are investing in real estate, options, precious metals, or employing leverage or other sophisticated investment tools to increase returns.

In order to carry out affinity frauds, the fraudster will be a member of the group they are trying to defraud such as a particular denomination or church. However, any close knit community or group such as an ethnic group, immigrant community, or racial minority will work. Fraudsters may also prey upon members with other commonalities such as teachers, union members, or military servicemen. The key to affinity fraud is that the fraudster can target the group and built up a high level of trust and confidence through the affinity connection to convince them to trust the fraudster with their life savings.

Business Development Companies (BDC) – Investment Risks to Be Aware of – Part II

August 20, 2014 | by Staff Attorney

In our prior post we recently highlighted, the rising popularity of non-traded business development companies (BDCs). BDCs may be one of the latest and greatest products that Wall Street is promoting that will provide outsized yield with less risk. As usual, these “new ideas” end with brokerage firms making lots of money and investors suffering the consequences.

BDCs make loans to and invest in small to mid-size, developing, or financially troubled companies. BDCs now fill the role that many commercial banks left during the financial crisis to lend to those companies with questionable credit. While BDCs are not new products, until very recently investors had only publicly traded closed-end funds that acted like private equity firms to invest in. These funds are risky enough. During the last downturn some of the publicly traded funds fell by 60%, 70% or more.

Like their non-traded REIT cousins, non-traded BDCs utilize a non-traded REIT-like structure and promote very high yields of 10% or more. There are some differences between BDCs and REITs, BDCs are regulated under the 1940 Act that governs mutual funds. There is also a big difference in valuation. BDCs are valued quarterly while non-traded REITs publish their valuations no later than 18 months after the offering period.

Business Development Companies (BDC) – The Next Risky Wall Street Cash Cow?

August 19, 2014 | by Staff Attorney

Since the financial crisis, the product development squad on Wall Street has been hard at work putting new spins on old ideas. The usual plan is merely to rebrand an old idea with a new label and convince investors looking for the latest and greatest product that the investment will provide outsized yield with less risk. It’s no coincidence that these new ideas make lots of money for the brokers selling them.

Enter the non-traded business development companies (BDCs). Now that many regulators and investors have begun to wise up and sour on the high commission and uncertain return approach offered by non-traded REITs, BDCs have entered into the fray as the non-stock market, non-real estate, high yield alternative. However, BDCs appear to be just as speculative – likely even more so – and inappropriate for most investors as non-traded REITs with many of the same failings such as obscenely high up-front fees, limited liquidity, and reliance on leverage to juice returns.

BDCs make loans to and invest in small to mid-size, developing, or financially troubled companies. BDCs have stepped into a role that many commercial banks left during the financial crisis due to capital raising requirements. In sum, BDCs lend to companies that may not otherwise get financing from traditional sources. While BDCs are not new, until very recently the market has been served by publicly traded closed-end funds that act like private equity firms. Just like the market was served just fine by publicly traded REITs before the non-traded variety showed up on the scene. One would think that the publicly traded BDCs provided high enough returns and were risky enough for even the most speculative investor considering that during the last downturn some of the funds fell by 60%, 70% or more. But greed is good.

Bank Loan ETFs – Buyer Beware

July 11, 2014 | by Staff Attorney

A recent statement by BlackRock Inc (BlackRock) Chief Executive Larry Fink concerning leveraged exchange traded funds (Leveraged ETFs) has provoked a chain reaction from the ETF industry. Fink runs BlackRock, the world’s largest ETF provider. Fink’s statement that structural problems with Leveraged ETFs have the potential to “blow up the whole industry one day” have rattled other ETF providers – none more so than those selling bank loan ETFs. Naturally, sponsors of Leveraged ETFs, a $60 billion market, called the remarks an exaggeration.

As a background, leveraged ETFs use a combination of derivatives instruments and debt to multiply returns on an underlining asset, class of securities, or sector index. The leverage employed is designed to generate 2 to 3 times the return of the underlining assets. Leveraged ETFs can also be used to return the inverse or the opposite result of the return of the benchmark. While regular ETFs can be held for long term trading, Leveraged ETFs are generally designed to be used only for short term trading – sometimes as short as a single day’s holding. The Securities Exchange Commission (SEC) has warned that most Leveraged ETFs reset daily and FINRA has stated that Leveraged ETFs are complex products that are typically not suitable for retail investors. In fact, some brokerage firms simply prohibit the solicitation of these investments to its customers, an explicit recognition that a Leveraged ETF recommendation is unsuitable for virtually everyone.

Despite these dangers, bank loan Leveraged ETFs may be an easy sell to investors. Investors in fixed income instruments are compensated based upon the level of two sources of bond risk – duration risk and credit risk. Duration risk takes into account the length of time and is subject to interest rate changes. Credit risk evaluates the credit quality of the issuer. For example, U.S. Treasury’s have virtually no credit risk and investors are compensated based on the length of the bond. At the other end of the safety spectrum are low rated floating-rate debt – what bank loan Leveraged ETFs invest in. These funds are supposed to reset every 90 days in order to get exposure to the credit side but not take on much duration risk.

Unsuitable IRA Investments On the Rise – Part III

June 25, 2014 | by Staff Attorney

This article continues our prior posts concerning a recent report by Bloomberg that noted the rise in rollovers from 401(k) plans into IRA accounts. The article pointed to concerns by regulatory agencies and investors concerning the suitability of the investment choices being recommended by brokers soliciting rollovers.

In another example, a mechanical engineer for Hewlett-Packard in Puerto Rico, rolled over $150,000 from a 401(k) to an IRA with UBS. His broker Luis Roberto Fernandez Diaz, recommended Puerto Rico municipal bond funds that contained a 3 percent upfront sales fee and 1 percent annual expenses. Fernandez’s brokercheck lists 17 customer disputes from 2009 through 2014. As we have reported on multiple occasions, our firm represents investors in claims against UBS concerning the firm’s practices in overconcentrating many of their client’s assets in these speculative highly leveraged bond funds. Those articles can be found here, here, and here.

In the case of an IRA, it makes little sense for a financial adviser to recommend investing in municipal bonds because the bonds main advantage is tax avoidance which already is a benefit of investing in an IRA. The investor interviewed by Bloomberg, says that the bonds plunged in value because of the deteriorating finances of Puerto Rico and are only worth $90,000.

The Failure to Protect the Public From Securities Fraud – Part II

June 20, 2014 | by Staff Attorney

As discussed in Part I, the primary defense to preventing securities fraud is has been to “bar” the person from the industry and to instruct the criminal to stop committing fraud. Despite the evidence that the slap on wrist approach has been ineffective, some lawmakers continue to think barring individuals and educating the public is the best way to stop securities fraud.

Yet, according to Futures Magazine, during the hearing Sens. Susan Collins (R-ME) and Bill Nelson (D-FL) stressed the importance of “consumer education” to prevent future scams. If only we could convince senior citizens to spend their golden years reading CFTC and SEC news releases and memorize the names of hundreds of barred fraudsters each year maybe we can turn the tide in this fight – right. Great game plan. At least Sen. Claire McCaskill (D-MO) understood the disservice the education alone approach would provide the investing public by stating that “The first line of defense is not consumer education,” but rather “putting the crooks in prison.”

The hearing also featured testimony of a former fraudster, Karl Spicer. Spicer was convicted for ripping off investors in a metals scam. Spicer’s testimony also clearly stated that it is government agencies failure to instill fear into fraudsters that has resulted in no progress in investor protection. Without real world consequences, criminals merely go from scam to scam and will unapologetically continue to swindle. Spicer stated that “With all due respect to the civil authorities, the people that I have encountered…don’t really respect the civil authority bans.” In fact, “The gentleman I was with had a CFTC ban, he cooperated; he had a ban and he still went about doing business the very next day.”

The Failure to Protect the Public From Securities Fraud – Part I

June 19, 2014 | by Staff Attorney

If someone broke into your home and stole hundreds of thousands of dollars of your possessions you expect that person to go to jail. But what if the consequence was merely to pay a fine and a court ordered bar from breaking into homes. Would you be alright with that outcome? Could such an approach really stop or even deter criminals? Could you imagine lawmakers arguing with you that the key to preventing more burglaries is to inform homeowners about locking their doors and windows and installing alarms – but not jail. If such an approach sounds silly then why have we accepted this approach to securities fraud.

The primary defense to preventing securities fraud is simply to “bar” the person from the securities industry and to instruct him or her to stop committing fraud. For many recidivist fraudsters, being barred from the industry is merely part of the career plan. Often times being barred from the industry merely frees the fraudster from the shackles of having to conceal their fraud within the confines of industry supervision. After being barred fraudsters are often in a perfect position to continue stealing from investors. Think about it – they have been industry trained, have spent years learning their craft, and have established many contacts and industry connections that they can now utilize for their post-industry frauds.

Yet regulators and lawmakers seemingly fail to grasp the very simple principal that those who commit securities fraud need to go to jail – period. Recently, the Senate presented findings of the Senate Special Committee on Aging concerning investigations gold investment scams targeting Florida seniors. The hearing clearly exposed how securities regulators, in this case the Commodity Futures Trading Commission (CFTC), has no ability to prevent securities fraud and protect the investing public.