The annals of stockbroker skullduggery are extensive indeed, and getting lengthier by the day. There are the brokers who abscond with funds, or confidentially convince clients to invest in scams outside the purview of their brokerage, or "churn" accounts (engage in excessive buying and selling), claiming that was what the client wanted.
One scam prevalent these days involves brokers coaxing clients to take out home-equity loans, or credit-card debt, to play the market. Clients are then urged to trade on "margin," leveraging their accounts by borrowing from the brokerage. Such actions, while possibly unethical, are not illegal.
But then the broker crosses the line by urging the customer to leverage the account in excess of the legal limit. With that over-leveraged account, the broker proceeds to trade heavily, or "churn." That churning generates big transaction fees for the client and big commissions for the broker.
"I had a client who, on the advice of his broker, went out and borrowed more than $100,000 on his house and credit cards," said Steve Buchwalter, an Encino-based lawyer who often represents clients in cases against stock brokerages. "Then the broker heavily traded the account. The turnover rate was 17 for a nine-month period." (That means if there was $100,000 in the account, the broker bought and sold $1.7 million worth of investments.)
Further, the broker "margined" the client at 50 percent effectively doubling the client's investable funds. (The term "margined at 50 percent" means leveraging the account by 100 percent. For each $1 of investable funds, $1 is borrowed, resulting in an account that is 50 percent margined.)
Doubling investable funds also doubles the broker's potential commissions. Those commissions, when combined with interest payments on the margined funds, all but guarantee that the client will lose money, even in a bull market, said Buchwalter, who has filed for arbitration in the matter and can't reveal further details.
The client was caught in a vicious cycle once he was lured in by hints of lucrative returns, he realized he had interest payments to make, and so felt compelled to undertake even higher-risk strategies to make the plan profitable.
"The 'borrow money on credit cards' advice is something we are seeing more of right now," he said.
The travails of Buchwalter's clients are not unusual. The files of NASD Regulation, the arm of the National Association of Securities Dealers charged with enforcing disciplinary actions, are filled with actions taken against brokers for allegedly doing wrong to their clients.
For example, Bernadette Jones, a stockbroker in Pomona, was barred from the industry in October after the NASD found she had taken $6,000 from a client to buy life insurance but instead bought a policy for $1,483, and pocketed the rest. She was also fined $3,500, and required to pay restitution to her firm.
Bigger fines are assessed on brokerage firms that are caught allowing, or possibly even encouraging, clients to "margin" their accounts in excess of the 50 percent legal limit. For example, J.B Oxford & Co., a brokerage in Beverly Hills, was recently censured and fined $20,000 for failing to maintain margin requirements on customers. The firm neither admitted to nor denied the allegations, but consented to the censure and fine.
When brokerages "overlook" excessive margins, it is sometimes because they want clients to invest in certain stocks that they say are ready to go up. When the clients start investing, the stock rises. But that uptick is often only temporary, fueled by new investor money, rather than improving fundamentals.
NASD spokeswoman Nancy Condon says another common problem involves brokers who entice clients to take part in private investments beyond the purview of the brokerage.
"We enforce a lot of actions on conversion (theft), and churning," she said. But some say the churning problem has actually decreased in the last four years, due to the increasing use of computerized surveillance by brokerage compliance departments.
"If there is a broker trading heavily now, it will quickly be caught by the compliance department and the branch manager will call the broker and want to know about the trading," said John Marrone, branch manager for Cruttenden Roth in West Los Angeles.
Also, some larger brokerages, such as Merrill Lynch, now reimburse brokers by a percent of client assets under management, not on commissions. That takes away a broker's economic incentive to trade or churn.
Many in the securities industry speak about a gullible public being enticed by telephone boiler rooms to invest in "hot" Internet stocks. However, such operations usually do not involve licensed stockbrokers, who sit in offices that are visited by the investing public.
Not So Hot Stock Tip
Common Scam: A practice called "conversion."
How It Works: A broker advises a client make an investment in something besides publicly traded stocks and bonds, and beyond the supervisorial range of the brokerage. Often, it's described as private stock, as a way to invest "on the ground floor" before the company goes public. The client is advised to make out a check to some entity other than the brokerage usually an entity controlled by the broker. Clients can be strung along, even for years, on the promise of a huge payday.
How It's Detected: Clues of conversion include a broker suggesting that a client make a private side investment, or that the client make out a check to the broker. Conversion would seem even likelier if the broker becomes defensive or evasive upon being asked if the branch manager is clued in to the arrangement.
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