FINRA to Level the Arbitration Playing Field

Five years ago, I sent a letter to Congress advocating the elimination of the so-called “industry representative” from investor arbitration proceedings administered by FINRA. Since then, I’ve written several op-eds and numerous blog posts on the subject in the hope that FINRA would eliminate the requirement that a representative of the securities industry sit on all investor arbitration panels. Today, FINRA announced a proposal to permanently give investors the option of “all-public” panels, finally freeing them from Wall Street’s influence.

FINRA’s decision will assuredly help level the playing field for investors. Previously, securities industry representatives tended to side with Wall Street and their fellow brokers. The practice was akin to suing your chiropractor and arguing your case in front of another chiropractor.

Needless to say, this is an important step, however, there are other improvements FINRA could make to the arbitration system as well. Such as, a more diverse pool of panelists that is more reflective of the U.S. population.

Also, arbitration proceedings shouldn’t be so secretive. FINRA should consider allowing observers into arbitration proceedings. If journalists or other watchdogs were allowed to attend, investors could see for themselves how brokerage firms mistreat their own clients and important precedents could be set.

Having said that, FINRA deserves credit for listening to investors and their representatives. To be sure, this is a win for individual investors.

Attending the NASAA Conference

This afternoon I was in Baltimore, Maryland attending the National American Securities Administrators Association (NASAA) conference, where I took  part in a panel discussion entitled “Guiding Investors Through the New Market.” My comments focused on a number of key investor issues including the need for a fiduciary standard, the lack of uniform federal regulation and the general failure of the Dodd-Frank bill.

I also highlighted the imbalance between state and federal regulation. While state regulators are taking a stand on behalf of investors against large financial institutions such as Bank of America and Citigroup, federal regulators have consistently remained asleep at the wheel.

I’ve submitted a more detailed position paper detailing these issues into the conference record.  You can view the document here.

UBS Gets Hit Again

An arbitration panel ordered UBS to pay a small business in Maryland ten times the amount it lost as a result of its auction rate securities (ARS) holdings. The assets were frozen when Wall Street stopped supporting the ARS market and overnight investors who were told ARS’s were “cash equivalent,” found themselves without liquidity, or “oxygen” as the owner of the Maryland business described it.

As I stated in today’s Wall Street Journal, “This case sends a shot across the bow for Wall Street firms that if they violate securities laws, they can be held liable for consequential damages.”

The Maryland business asserted that because of UBS’ dubious sales practices, their business suffered significant damages. The business went from having 60 employees to 15 because of a lack of cash. Attempting to add insult to injury, UBS tried to argue that the business failed because of its management and not a lack of cash, but an arbitration panel didn’t buy it.

You may remember that David Aufhauser, UBS’s general counsel, was banned from the industry last year and ordered to pay a penalty to settle insider trading charges after he dumped his ARS holdings. He was the recipient of an internal company email warning of risk in the ARS market. Obviously, the Maryland business in this case and hundreds of other UBS customers weren’t afforded that same alert.

This is yet another example of UBS putting its own interest ahead of its customers. Fortunately, an arbitration panel made UBS pay dearly.

Leveraged ETFs: Should Investors Demand Their Money Back?

It’s an age-old trick: if one’s good, then two’s better.  But when it comes to leveraged exchange traded funds or leveraged ETFs and inverse exchange traded funds…that isn’t necessarily the case.

Over the weekend the Wall Street Journal reported that Massachusetts Secretary of the Commonwealth William Galvin sent subpoenas to several top financial firms including Ameriprise, UBS, LPL Financial and Edward Jones.

A leveraged ETF is really just a traditional exchange traded fund on steroids.  The returns are goosed, but the losses are magnified as well.

The groundswell of anger surrounding these products has been steadily increasing for a few weeks and we’ve been getting calls from investors interested in pursuing cases after getting stung by these instruments.

FINRA sent a letter to its member firms warning that leveraged ETFs and inverse ETFs were unsuitable for retail investors.  A great many other firms have abandoned them as retail products altogether.  For his part, Secretary Galvin wants more information about how brokerage firms marketed leveraged ETFs to investors and why so many lost their shirts.  According to the article, leveraged and inverse ETFs held $32.8 billion at the end of June, up $11 billion at the start of 2008.

It’s possible, if not likely, that these instruments were sold to investors as a way to hedge against particular portfolio strategies or even as a cheaper alternative to mutual funds.  But investors weren’t told exactly how speculative and costly leveraged ETFs were.  In fact, to properly use them, investors basically had to bet on what the market would do that day.

Indeed, a buyer of a leveraged or inverse ETF must have the wherewithal to make significantly sophisticated trading decisions everyday based on how the fund’s derivative index performed and guess which way it will move the following day.  I know from over 20 years of working with investors that they are notoriously passive and commonly afraid to take corrective measures without the prodding of their financial advisor.  For this reason alone this is an unsuitable product.

Leveraged ETFs, and ETFs generally, are also touted for the tax efficiency. While this fact may be true it would have no bearing on a retail investor using a tax-deferred IRA or other tax-deferred accounts (or indeed those who are already tax-exempt).

Finally, another major reason for the deserved outrage is that leveraged ETFs look like low-cost mutual funds that are pegged to a certain index or basket of securities.  But in reality they do not track the index like a passively managed mutual fund would.  Rather they trade on the open market and “close” everyday and restart.

This aspect of the instruments is important because it compounds the fund’s expenses, which in the case of the leverage ETFs are very high because of the cost of borrowing.  On a good day, when the investor guessed right, he or she might get twice the derivative index’s return, less expenses.  But on a bad day, the investor takes twice the loss, plus the expenses.  So to make up for the loss, the investor needs two days on the upside to make up for the one day loss.  For every day an investor bets incorrectly, the expenses compound so the break even point (i.e. the index) gets further and further out of reach.

It’s almost impossible to justify this expense for a retail investor.  And a financial advisor or broker cannot say that somehow a leverage ETF is more suitable than a simple index fund.  Thus, the likelihood for another barrage of investor cases is very high.

Tips to Avoid a Ponzi Scheme

1. Be wary of recommendations from brokers or financial advisors based solely on the fact that they are a member of an organization or religious or ethnic group to which you belong.
2. Investigate the investment thoroughly and check the truth of every statement you were told about the investment.  You can research on the Internet any stocks or other investments that are being pitched.
3. Be very cautious and avoid promises of “guaranteed” returns or spectacular profits.  In the last year or so, the market has declined over 40%.  Anyone promising to make money such as 10 or 15% on an annual basis when the market is going down is likely to be a phony.
4. Be skeptical of any investment opportunity that is not in writing.  If someone has something real to offer they will put it in writing, otherwise it is not real if simply said orally.
5. Don’t be pressured or rushed into investing in a “once in a lifetime” or “can’t miss” opportunity.  Legitimate investment opportunities are not rushed to investors and investors must be given time to carefully think about and investigate the proposed opportunity.
6. Check out your brokers on FINRA.org.  Check out your broker’s customer complaint, regulatory history and employment history .
7. Check out investment advisors on the SEC’s database.
8. Do not do business with unregistered investment advisors.
9. Avoid anyone who has prior customer complaints or regulatory problems and avoid brokers or advisors who have switched firms repeatedly (at least three changes in a five year period).
10. Make sure that any investment is held at a known reputable financial institution (Citibank, Bank of America, etc.) and that there is a specific account with your name on it and an account number.  Verify that the money is in fact being held by the bank.
11. Never make a check out personally to an investment advisor or a small unknown company.  It is possible or even likely that your money will be stolen.
12. Check to see if the investment advisor has a website.  If there is no website, this is a big red flag that your broker or advisor is not legitimate.
13. Make sure you understand the investment advisor’s strategy and what he or she will put your funds in.  If you don’t understand it after speaking with the advisor and doing your own independent research, avoid the investment.
14. If it‘s too good to be true, it probably is.

Fannie Mae Preferred Stock and Freddie Mac Preferred Stock: As Shares Plummet, Retirees Feel the Pinch

If you asked any Wall Street broker or securities analyst what constitutes a “conservative” investment back in 2005, Freddie Mac preferred stock and Fannie Mae preferred stock – and the preferred stock of other financial services companies for that matter – would have been atop the list.  Fast forward to the beginning of 2007 and any broker worth his or her Series 7 certification should have told clients to bail out and seek shelter in real cash equivalents as the credit crisis showed no signs of relenting.

Unfortunately, we are hearing from many investors that they were not told of the mounting risks of holding onto Fannie Mae preferred stock and Freddie Mac preferred stock.  After all, Fannie Mae preferred stock and Freddie Mac preferred stock, along with preferred stocks from many financial institutions, were pitched as income-generating “conservative” havens.  In fact, many brokers falsely touted Freddie Mac and Fannie Mae preferred stock as being “backed” by the U.S. government.  But even as the alarm bells rang clear, and investors questioned whether holding Fannie Mae preferred stock and Freddie Mac preferred stock was in their best interests, we are hearing that brokers advised them to double down on Fannie Mae preferred stock and Freddie Mac preferred stock as late as January of this year.

While Fannie Mae preferred stock and Freddie Mac preferred stock was traditional pitched “as safe as bonds”, they never were bonds.  They are an entirely different classification all together.  It’s true.  There was once a time that preferred stock from a financial services firm would constitute a conservative investment.  However, by about May 2007, with the credit crisis in full swing, brokers had a responsibility to shift strategy which is a normal reaction to changing market conditions. Regrettably for investors, many brokers did not alter their client’s portfolios and continued to sell Fannie Mae preferred stock and Freddie Mac preferred stock as late as the last three months when it was clearly apparent that there were huge risks. It is equally troubling that a large number of the victims are elderly retirees or those nearing retirement. Brokers that I have spoken to say it would be unreasonable to sell a person in or nearing retirement more than 20% of their investments in preferred stock. There are some who had 100% of their investments in Fannie Mae preferred stock, Freddie Mac preferred stock and preferred stock of other financial institutions.

To many that are not versed in the ways of Wall Street, this sounds unbelievably perverse.  While I can’t argue with that sentiment, there is an explanation. Seeking to raise $6 billion, Freddie Mac began issuing preferred stock in November, pricing it at $25 a share with a fixed dividend rate of 8.375% through December 31, 2012.  Fannie Mae followed a month later with an offering priced at $25 a share with a fixed rate of 8.35% to 2010.  It’s no coincidence that the lead underwriters for the Fannie Mae preferred stock transaction were Merrill Lynch and Lehman Brothers, which as of today no longer exist for all intents and purposes.

Faced with holding so much inventory, the underwriters unleashed their sales force and unloaded the toxic Fannie Mae preferred stock and Freddie Mac preferred stock by any means necessary. You can envision the pitch including a comment that implies the U.S. government would never let shareholders take a bath on Freddie Mac preferred stock and Fannie Mae preferred stock.

Needless to say, the government’s takeover of the two firms has decimated the value of Freddie Mac preferred stock and Fannie Mae preferred stock.  Not only are the dividends suspended, but the value of the preferred shares in both companies is less than $3 per share.

At the very least, brokers and financial advisers should have warned their clients against holding Freddie Mac preferred stock and Fannie Mae preferred stock and reallocated their portfolios.  If the evidence shows that brokers didn’t warn their clients of the risk or that concentrated holdings of Freddie and Fannie preferred did not fit with a client’s risk profile, they will be held accountable in a FINRA arbitration hearing.  Indeed we will be filing claims shortly.

The Fannie Mae preferred stock and Freddie Mac preferred stock debacle isn’t the only example of unbridled greed that has typified Wall Street.  Preferred shares of financial institutions were aggressively sold to conservative investors, perhaps because the commissions for brokers of these securities were greater than fixed-income bonds.

These are dark days for Wall Street, no question.   But over the past twenty years, its clear that brokers, CEOs and risk managers alike have learned nothing from the mistakes of their predecessors.  So I’m saving my empathy for the investors who are the true victims.