Can I Learn Whether Investor or Regulator Complaints Have Been Made Against a 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 Securities Regulator or Corporations Commissioner of the state in which the broker works. 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. The best way to learn 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.

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.

Can I Learn Whether Investor or Regulator Complaints Have Been Made Against a Financial Planner or Money Manager?

Investors can obtain 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.

What Is the Difference Between a Stockbroker, an Investment Adviser and a Financial Planner?

Stockbrokers must be licensed with the NASD and registered with a brokerage house that is a member of the NASD. Stockbrokers are paid on a commission basis according to the volume of securities trading by their customers. Investment Advisers and Financial Planners can be, but usually are not, stockbrokers. Indeed, there is a bit of a feud going on at this time between Stockbrokers, on the one hand, and Investment Advisors and Financial Planners, on the other hand. Each side sees the other as somehow inferior. Be that as it may be, Investment Advisors and Financial Planners normally charge a flat advising fee or take a percentage of the investors' assets under management for their services. However, sometimes Investment Advisers and Financial Planners actually obtain more money based on the investments they recommend, although this fact may not be readily apparent to the client, as the compensation may be hidden in the form of undisclosed kickbacks or buried payments.

Who Regulates Investment Advisers and Financial Planners?

Investment Advisors and Financial Planners are licensed by states, or if they have $25 million or more under 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.

Is There a "Bad Boy" List of Guilty or Fraudulent Securities Firms?

No. However, nearly all securities firms have been found to have engaged in fraudulent behavior one time or another, and many have repeatedly been found guilty of serious misconduct toward investors. It is possible to request information regarding the firm's regulatory history by obtaining a "Broker Check" report from the NASD.

Are There Any Valid Concerns Regarding Investing in 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. One of the main problems is that unlike stocks and mutual funds, bond prices are not clearly posted. 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."

Problems exist because stockbrokers can make more money if they recommend certain bonds that are the property of their firm, rather than bonds that are being sold on the open market. 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. Additionally, and more seriously, stockbrokers are paid more to sell riskier bonds.

Are There Problems That Can Arise When Investing in Mutual Funds?

Mutual funds normally pay very high compensation to the selling broker. So called "A" shares, still the most frequently sold share type, pay an approximately 4 percent up-front commission 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)

Mutual Fund Switching occurs when a fund that is designed to be held for a certain number of years is sold "before its time" in order to generate income for the broker. Normally, when a broker recommends that the investor sell a mutual fund in order to obtain money to invest in another mutual fund, the broker is required to have the investor sign what is known as a "Switch Letter." The Switch Letter is supposed to explain in no uncertain terms that the idea of selling one mutual fund to buy another has certain drawbacks, including, financial losses. Unfortunately, often times, either the brokerage house does not actually notify the investor of these facts, or the broker persuades the investor that, regardless of what the Switch Letter says, the transactions is in the best interests of the investors. Yet, this is seldom true.

When Are Fee-Based Accounts Always Better than Commission Accounts?

In a Fee-Based account, an investor is usually charged anywhere from half a percent (50 basis points) to three percent (300 basis points) of funds on account annually rather than a transaction commission. The idea is that if there will be a large number of trades, the investor will save money.

Although this sounds favorable for investors who wish to trade actively, brokers rately voluntarily recommend that active trading clients use this type of account. The reason is simple, there are huge fees to be made on accounts where the client actually wishes to trade the market. Stockbrokers are usually paid based on the volume of trades, so if they know that there will be a large volume of trades, they have no economic incentive to recommend a type of account that will deprive them of the economic benefits of active trading.

A potential problem with any account, including a fee based account, is the use of margin. Brokers make more money if margin is used, regardless of whether or not the account is commission based or fee based. This is because margin increase the amount of the assets in the account, and this is true, regardless of whether or not the account is commission or fee based. The use of margin will always increase the amount of compensation paid to the broker, and this is so whether or not the investor has substantial gains, or losses.

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.

Putting Aside Intentional Lies, Can Brokers Be Guilty of Merely Not Telling the Whole Truth?

Obviously, a stockbroker who tells an "out and out" lie can be held accountable for losses caused by the fraud. It is also true, however, that a stockbroker can be liable to a customer if the broker tells only part of the story, or in other words, fails to tell the entire truth. This is a form of fraud also know as the omission of material facts. Usually, this happens when a stockbroker recommends an investment by touting the positive elements of the program, while at the same time, conveniently failing to mention negative information. For example, if a stockbroker recommended an investment on the basis that a drug company had originated a new medicine that treated a serious disease, but at the same time, did not say that the drug had failed critical FDA tests and therefore might never make to the market, this would constitute a form of fraud by omission.

What is the "Suitability Rule"?

The so-called "Suitability Rule" was originated by NASD Conduct Rule 2310, which provides:

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.
4. Such other information used or considered to be reasonable by such a member or registered representative in making recommendations to the customer."

Putting aside the technicalities, the "Suitability Rule" really stands for the proposition that a stockbroker is a professional who is supposed to have expertise in recommending investments. If a stockbroker recommends an investment, the reason for the recommendation is supposed to be that the investment is good for the investor. If a stockbroker recommends an investment because it pays higher commissions, and the stockbroker really does not care if the investment is appropriate for the investor, the rule has been violated.

What is the New York Stock Exchange "Know Your Customer" rule?

NYSE Rule 405 mandates that stockbrokers are "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..."

If an Investor Has a Bad Idea for an Investment, That Is Clearly Harmful, Does a Broker Have Any Obligation to Point this out to the Investor?

Stockbroker are required to act in the best interests of their clients, even if this means that the stockbrokers will earn less money. This really has to do with the idea that an investor is seeking professional guidance from the broker. It might be compared to the situation where a person who is ill seeks the assistance of a doctor. The doctor, acting under the rule that physician's first rule is to "do no harm," will not go along with the patient's desires if the doctor deems that the wishes of the patient are contrary to medical wisdom.

Does a Brokerage Firm Have an Obligation to Supervise the Stockbrorkers Working for the Firm?

Yes. Brokerage firms 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:

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.

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 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.

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.

What Is a "Turnover Rate"?

"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. A high Turnover Rate tends to indicate churning or excessive trading.

What Is the "Cost-to-Equity Ratio"?

"Cost-to-Equity Ratio" is computed by dividing total charges on an account by the average net equity in the account over given period of time. For instance, say a customer has a $100,000 equity account and the broker's commissions for the year were $20,000. For that year, the "Cost-to-Equity Ratio" for the account would be 20 percent.

What this really means is that the investor would have to earn a return of 20 percent during the year on the funds on account just to meet the expenses of the account.

Therefore, the higher the Cost-to-Equity Ratio for an account, the greater the risk of loss to the investor and the higher the compensation to the broker.

What is "Day-Trading," Also Know As "In-and-Out" Trading?

"Day-Trading" or "In-and-Out Trading occurs when the stockbroker purchases a security and resells it after a relatively short duration (either in the same day, or within a matter of days or weeks), and then uses the proceeds from the sale to purchase another security that is of the same general type. This type of trading can result in gains during a raising market, but will nearly always cause losses in a declining market, and overall, it will usually cause losses over time and it is deemed to be highly inappropriate for most investors, particularly retirement oriented investors.

What is a "Happiness Letter" or a "Comfort" Letter?

Often, when brokerage firms detect abuses in an investor's account the firm will send to the customer a "Happiness Letter" or a "Comfort Letter." The purpose of these letters is to establish a paper trail showing that the investor is pleased with the actions of the stockbroker, and is well aware of what is happening in the account.

These letters will normally not mention the harsh facts. They will generally state something to the effect that "we are pleased to have you as a client, we value your business, if you have a problem with your account please contact the firm." Sometimes, they may say "unless we hear back from you, we will assume you accept the risks associated with such aggressive trading in your account." Typically, a failure to respond negatively by an investor is not damaging to his or her case since many times, the investor is not aware of the fraud until some considerable time after the "happiness" or "comfort" letter was issued. In addition, it is common for a broker to tell a client who received a happiness letter not to worry about it and that it is just a formality. A letter of this type is generally not given a great deal of credence in an arbitration hearing.

What Is Meant by the "Well Managed Account" Measurement of Damages?

The so-called Well Managed Account" measurement of damages focuses on what the investor would have gained by being invested in a typical portfolio or mutual fund consistent with their objectives at the time the broker was "managing" the account. For instance, say a 40 year-old investor brought a $1 million portfolio to a stockbroker. The portfolio consisted of $500,000 in blue chip stocks and stock index funds and another $500,000 in government and high-grade municipal bonds. Instead of leaving the account in its properly diversified state, the broker decides to liquidate the holdings and purchase technology and biotechnology stocks and stock options.

The "Well Managed Account" measurement of damages would focus on the difference between what that the investor's return was under the broker's direction and what the account would have returned if the broker had left the account alone in its already well-diversified position. In the scenario outlined above, if the broker lost 25 percent of the investor's portfolio due to the brokers recommendation of unsuitable investments over a 12 month period and the account would have returned, but for the broker's negligence, 10 percent a year, then the investor's damages under a "well managed account" measurement would be $350,000 ($250,000 in out of pocket losses plus $100,000 of damages for what the account would have returned if the broker had not acted negligently).

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