Wealthy Advice
It is a common perception that the wealthy have the best advisors, and many do, particularly in the areas of legal and accounting. In the investment arena, however, control is often delegated to commissioned salesmen, many times not the most objective advisors. Many times wealthy investors have several brokers that generate a great deal of commissions each year, yet no strategy is initiated to complement the total portfolio. Therefore, one broker may be buying Amgen at nearly the same time the other broker was selling - resulting in a taxable event to the client with absolutely no change in the client's net portfolio, minus the two separate commissions. Most mutual funds purchased three years ago in emerging markets lost money each year. If this was not bad enough, in each year the funds distribute taxable income, thus creating a tax debit on top of the losses. Many times the client is not told of this and is not kept informed regarding the portfolio's performance, total costs, or tax exposure. It seems that many times commissioned sales people are rewarded for keeping clients in the dark. Quite often brokerage clients are told how well they are doing when in actuality they are under-performing the market. Strategies to reduce tax consequences, costs, or risks are ignored for the sake of the ultimate goal of generating as much commissions possible per portfolio dollar. If brokerage clients knew their total cost (most of which are hidden and not disclosed), their true net returns and the risk taken, many investors would be in for a huge surprise. The trend toward fee only money managers and advisors is ever growing, but it still is amazing that many wealthy investors are still left in the dark. Here are some questions for your broker (or potential broker/advisor) that could prove very enlightening:
- How long have you been with the brokerage firm? How long in the securities industry? What was your prior employment and why did you leave it?
- Where do you get your investment recommendations? (hint: brokers only have capacity to follow advice from corporate headquarters as they can not act as investment advisors or portfolio managers themselves).
- Will performance including total expenses and all commissions/fees be clearly disclosed? (hint: obtain running totals weekly or monthly)
- What is the broker's theory on selling securities, profit taking, tax planning, etc.? (hint: get specifics on past recommendations and tax consequences)
- Do you now or have you ever received bonuses, extra commissions or perks of any kind for selling a particular product?
- How many clients does the broker directly service and does the broker regularly meet with each client?
- Do you have any client references? (hint: make sure their existing clients actually know their total cost, net performance, risk and tax efficiency. The above referenced wealthy investor many times happily refers new business to their broker(s) before they realized their actual costs, degree of risk and actual net performance).
The other major mistake that even the wealthy still make is buying mutual funds in taxable accounts. In doing so they are buying the potential tax liability of the fund's unrealized gains. Mutual funds also have the disadvantage of not having any control as to the timing of realizing its gains and losses. Quite often mutual funds will also have higher annual costs than the average individually managed portfolio. Despite these disadvantages, mutual funds can be a great vehicle if selectively purchased for smaller amounts of money because they usually provide immediate diversification. In addition, mutual funds make sense for non-taxable (retirement) accounts, since the embedded tax liability in mutual funds would not be a factor.
No Commission and Ultra Low Commission Trading
Most brokerage firms trade stocks for their own account. As a result, brokerage firms have inventories of stocks it wants to sell. Many times they will allow their brokers to buy the stocks at a discount and sell it to you at no commission. When you hear no (or severely discounted) commission, it may sound good; but if they mark-up a $10 inventory item to you for $10.50 that actually creates a 5% cost to you when a typical brokerage commission is 1 ½-2%.
For example, on September 10, 1998, Olde Discount Brokerage was fined $7 M by the Securities & Exchange Commission and National Association of Securities Dealers. The SEC stated that Olde encouraged brokers to push "special venture stocks" the company wanted to sell. The SEC claimed it was all but impossible for an Olde broker to earn a living without pushing these special venture stocks. If a customer asked how Olde made money on the no commission trades, Olde brokers were instructed not to talk about the spread between what they would sell the stock for and what they originally bought it for. Special venture stocks with the biggest spreads were posted with exclamation points on the broker's computer screens. Another factor with many brokers, and how Internet brokerage firms can offer such ultra low commissions, is the fact that they are paid externally for "order flow". This may not be a factor with a highly liquid stock in a very orderly market, but investors should be careful in a volatile market or when dealing with less liquid stocks.
Wrap Accounts and Fee Based Brokerage Accounts
Many brokerages are trying to move toward fee-based compensation, which they say aligns a broker’s interest more closely with the clients. A wrap account is a brokerage account that is managed with the customer paying an annual fee based on the size of the account rather than the traditional commission per transaction method. Many times the brokerage firm will hire (or allow you to select from their list of hires) an outside money management firm responsible for your account. The independence of such money managers may be in question if all trades have to go through said brokerage firm. Investors should be aware of this disadvantage (potential conflict of interest) and may wish to hire an independent money manager which is not dependent on future business in this fashion.
Over the past several years, many brokerage firms have added "actual" no-load mutual funds to their product line. Unfortunately in so doing, most make you sign up for their mutual fund program which charges 1% (sometimes up to 2%) for this privilege. Such no-load mutual fund programs totally negate the advantages of no load mutual funds, as these added charges have the same effect as having an annual 12b-1 charge. The same problem is applicable to timing services or portfolio management services by independent financial advisors that charge an annual fee based on assets in your account.
Resolving a Dispute With Your Advisor including Brokers, Insurance Agents and Financial Planners
You can usually resolve a dispute with your broker by talking with him or her directly. If that doesn’t work try the office manager or compliance officer. Make sure you put your complaints in writing and keep copies. After that, it depends on whether your advisor is a stockbroker, insurance agent or financial planner. It should be noted that they all can call themselves “financial advisors”.
Stockbrokers: Contact one of the 13 district offices of the National Association of Securities Dealers. You can find the number for your area in the phone book or via their website www.nasdr.com. The NASD also has jurisdiction over insurance agents and financial planners if they sell securities. Any disciplinary history of your advisor may be obtained via the above mentioned website or by calling (800) 289-999.
Insurance Companies/Agents: Contact the commissioner of your state insurance department if the complaint is regarding an insurance company or the National Association of Insurance Commissioners (816) 842-3600 or their website: www.naic.org.
Registered Investment Advisors/Money Managers: Contact the Securities & Exchange Commission’s office of Investor Education and Assistance at (800) 732-0330. The office will forward your letter to the firm. It should be noted that insurance agents and brokers may also face SEC jurisdiction in addition to the NASD, depending on the offense. Website: www.sec.gov
Independent Financial Planners: Most are registered with the NASD and/or SEC. Many small planners are regulated by their state securities administrators. You can find yours at the website of the North American Securities Administrators Association at www.NASAA.org or by calling (202) 737-0900.
Non-US Regulators and Exchanges
International Organization of Securities Commissions (IOSCO)
AUSTRALIA
Australian Securities and Investment Commission (ASIC): http://www.asic.gov.au/
CANADA
Ontario Securities Commission (OSC): http://www.osc.gov.on.ca/
Commission des Valeurs Mobilieres de Quebec (CVMQ): http://www.cvmq.com/english/
British Columbia Securities Commission (BCSC): http://www.bcsc.bc.ca/
Toronto Stock Exchange (TSE): http://www.tse.com
FRANCE
Commission des Operations de Bourse (COB): http://www.cob.fr/eng/index.asp
GERMANY
Bundesaufsichtsamt fur den Wertpapierhandel (BAWe): http://www.bawe.de/english/frame_e.htm
Bundesaufsichtsamt fur das Kreditwesen (BAKred): http://www.bakred.de
ITALY
Commissione Nazionale per le Societa a la Borsa (CONSOB): http://www.consob.it/
UNITED KINGDOM
Financial Services Authority (FSA): http://www.fsa.gov.uk
Securities and Futures Authority Limited (SFA): http://www.sfa.org.uk
Investment Management Regulatory Organization (IMRO): http://www.imro.co.uk
The Truth About Online Trading
DID YOU KNOW?
- Many trades placed through online brokers do not make their way to the market via traditional channels. Instead new trading systems called electronics communications networks (ECN's) are utilized to pit buyer and seller together. In theory ECN's were a way to avoid the markup of the professional traders (or middleman) on the NASDAQ market. In reality the ECN's have hidden costs that far increase the rock bottom commissions that online brokers typically charge.
According to the National Association of Securities Dealers, eight out of ten stocks traded on these networks receive inferior pricing. In a large part, that is because investors are trading only with other investors who are using the same network, rather than combining with all other investors in the broader NASDAQ marketplace. These networks may also be a principal cause of tremendous price swings, particularly in the popular internet stocks. Even investors who do not use these networks via online brokers should be concerned because they increase volatility and trading cost for everyone. Much of this added volatility and costs have been masked by a decidedly strong stock market, particularly among the NASDAQ leaders - high technology in general, internet in particular. The networks now account for 20% of trading in NASDAQ stocks. But not until we experience a full fledged market decline, will we be able to know whether the fragmented marketplace created by the rise of these ECN's will make it harder to sell on an orderly basis. Keep in mind, unlike the NASDAQ market makers they are trying to replace, ECN's do not commit any capital to maintain orderly markets in the stocks they trade. If the markets drop significantly, ECN's will have a much harder time providing liquidity. So it is imperative to know where your online broker is directing their order flow. Check time and sales on your orders, and if there are discrepancies, it probably has to do with such network order flow. There are other systems currently being implemented - some of which link trades on a flat fee rather than profiting from the spreads between the bid and asked prices. However, these systems are now still fragmented and create difficulty in matching the buyer and seller at the best price. We will keep you informed in regards to this developing situation of analyzing the true costs of online trading.
The Pitfalls of a Margin Account
The excitement of a strong bull market particularly in those speculative NASDAQ stocks created a surge in prices from November 1999 through February 2000. In conjunction, there was a rapid increase in margin debt rising 62% for 1999 - nearly half of this increase was during the 4th quarter of 1999 helping propel prices even further. Of course, we all know now what happened in March - April 2000 as NASDAQ prices plunged 39% (speculative NASDAQ high flyers dropped 50-90%). This is our whole case against margin. It not only increases investor risk dramatically but it also forces you to sell (because of margin calls once prices drop) at exactly the wrong time. On June 18th, 2000 the New York Times has an excellent article entitled "Chat Room Millions, Real Life Misery" which takes readers through real life situations of how the spring NASDAQ plunge forced investors to sell their multi-million dollar positions in high flying NASDAQ stocks right at the bottom. This is exactly why legendary investor Sir John Templeton has expressed for decades now - that borrowing money to buy stocks is wrong - no exceptions. If you are on margin please reduce your risk by implementing a strategy to eliminate (or at least dramatically reduce) your added exposure.
One final note, if your broker doesn't seemed concerned about your margin levels it could be because he/she actually is getting paid or rewarded for margin accounts. It is a solid profit center for brokerage firms, not to mention it also increases trading activity particularly in volatile markets. Morgan Stanley Dean Witter credits 15 basis points of broker's commissions on the average daily margin balances in client accounts. While Merrill Lynch counts margin interest torward its measure of "total revenue" which is used for broker deferred compensation calculations as well as qualifying for recognition clubs. It should be noted that both the NASD and NYSE have recently urged member firms to curtail broker incentive programs "that would promote the solicitation of margin accounts."
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We warn our visitors about the higher than disclosed risk in many bond funds sold by stock brokerage firms, insurance companies and banks. A good real life example of this can be seen from a recent Wall Street Journal article.
NASD Alleges That Dean Witter Misstated Risks on Bond Funds
By Randall Smith
(Staff Reporter of The Wall Street Journal)
More than $2 billion in bond-related mutual funds sold to investors by one of Wall Street's most powerful payers weren't all they were cracked up to be, according to regulators.
The National Association of Securities Dealers' regulatory arm, in a civil administrative complaint filed yesterday, alleges that Dean Witter Reynolds, now a unit of Morgan Stanley Dean Witter, violated the antifraud provisions of securities laws by misstating the risks of $2.1 billion of closed-end bond funds sold in 1992 and 1993.
The bond funds, marketed to 106,000 individual investors by Dean Witter before that firm's parent merged with Morgan Stanley in 1997, plunged roughly 30% after interest rates rose in 1994, the complaint says. The result, according to the NASD: Nearly 30,000 investors who sold the shares incurred a total of $65 million in losses.
"In the internal marketing campaign," the NASD says, "Dean Witter presented the Term Trusts to its brokers in a misleading fashion as a simple and safe investment, as an investment that was suitable for virtually all investors, and as a safe, high-quality alternative to CDs."
"The timing couldn't be better! Approximately $110 billion in Certificates of Deposits are rolling over in April. That's a high potential market for TCW/DW Term Trust 2003. Certificates of Deposit have traditionally been the choice of investors seeking safety and an attractive yield," said an excerpt from marketing material cited by the NASD, urging that brokers "really spell out the exciting feature so the TCW/DW Term Trust 2003 and you'll have yourself more sales than you calculate the commissions on. Everything you want from a CD and more!"
Dean Witter received more than $119 million in underwriting fees and sales concessions for the funds, which were sold between November 1992 and November 1993, as well as management fees of $7 million annually, the NASD says. But the funds were all forced to reduce their dividends by nearly a third in February 1995 because the coupons on the inverse floaters reset lower when interest rates rose.
These funds, which seek to return $10 a share, trade publicly on the New York Stock Exchange. As of December 1994, the funds were at the bottom of rankings for 28 comparable mortgage-bond funds with $9 billion in total assets for 1994 returns as tracked by Lipper Analytical Associates. They showed negative returns of 16.6% to 18.8%, and their net asset values had fallen from an initial $10 a share to a range of $7.07 to $7.36.
The NASD alleges the marketing materials were misleading because they "stressed the safety of the term trusts" by repeating that the securities they contained would be government guaranteed, "AAA rated," or "of the highest credit quality."
Dean Witter also used "high-pressure sales efforts at the regional and branch office levels, including the use of sales contests and sales quotas," the NASD says. Dean Witter brokers, the NASD notes, received higher commissions for the sale of such proprietary products, and were strongly encouraged to sell at least 75% of proprietary mutual funds and just 25% of outside fund investments. The NASD also says the firm marketed the term trusts to "elderly, conservative investors," selling more than $1 billion to those over age 60.
Another example of the importance of analyzing the costs and risks before you are sold an investment, soundinvesting.org helps investors avoid painfull mistakes.
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Separate Account Money Managers
One of the hottest areas now being pushed by the brokerage community is separate account money managers as opposed to mutual funds. There are many advantages to having individualized (separate) accounts rather than pooled monies like a mutual fund. Among the advantages include a customized approach, much better control over holdings allowing for lower tax exposure and better ability to coordinate entire assets due to more detailed and immediate reporting of actual transactions. As with mutual funds, however, it is imperative to select the right money managers. Getting information on how the money manager has done in down markets (protect your assets) as well as specific philosophy and total costs all should be detailed. The question is why is your broker suddenly pushing money managers rather than buy and sell stocks in your account himself or herself? First of all, the broker still gets the commissions (and/or share of the percentage money manager fees of wrap accounts) but no longer takes the risk of stock selection. So therefore the theory goes if your account does poorly, the broker has a good chance of maintaining the account (and the revenues guaranteed with ongoing commissions and/or fees) by just recommending a new money manager. In other words the blame goes to the money manager instead of the broker. So does this make it inappropriate to use your broker to establish a separate money manager? No, as long as the investor is aware of the following potential conflicts under such a situation.
Questions to ask your broker before setting up a money managed account:
What are the total cost and how much more am I paying by going through you (the broker) rather than directly with the money manager?
Two points to consider if the answer is that with your $50,000 or $100,000 you would not be able to go directly to these managers because their minimums are much higher than this statement may have merit depending on your situation. But just remember if an added 1% a year doesn't seem like much it equals $147,169.24 loss of money plus an opportunity cost at 10% per annum over 30 years.
If their response is their value added in selecting only the best follow up with the question below and ask how long they personally have been recommending separate accounts and a list of long term clients.
In the selection process, do you just consider money managers that will place all trades with your brokerage firm?
Many firms will have listings of the best money managers in their universe, but never explain that many leading money managers do not limit themselves to work with only one brokerage firm for your account. They feel these limitations significantly handicap their performance, and thus your brokers universe (choice of money managers) may omit strong money managers that would dramatically change their comparison numbers.
The analogy in sports would be best explained by the real value of home run statistics when not keeping track if it includes all the best of the major leagues or if stats are from a restricted universe like including minor league and small park statistics (a select group of managers that will work with XYZ brokerage).
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YOUR BROKERAGE AGREEMENT: WATCH OUT FOR THE FINE PRINT
Chances are, when you set up a brokerage account, you signed a form but barely glanced at the agreement or other paperwork that went with it. Who wants to plod through a lot of undersized print and oversized sentences?
But you should. If you do, you'll see some very ominous-sounding stuff. Some is mostly bark, but some can truly bite you. So you need to know where the hazards are and aren't.
Consider these examples:
- One October morning, you finally get around to reviewing an August brokerage statement and spot a $3,000 purchase you never authorized. Your agreement specifies that to get an error corrected, you must object within 10 days. So it's too late, right? Probably not, though you might have to go to arbitration to get your money.
- You trade on margin (your brokerage loans you some of your stake), and one day a major holding nosedives. Your broker doesn't call to say you must put cash in; instead, he simply sells a stock you wanted to keep, without your okay. Can he really do that? He sure can.
If either example seems surprising, it's time to dig out your brokerage papers, brew some coffee, and maybe find yourself a magnifying glass. But first, read the rest of this article, so when you see all that fine print, you'll understand what it really means.
Then you can take steps to protect yourself. You may become more careful about your relationship with your broker, and review more fully any communications you receive. You may start creating a better "paper trail" of your own, too. That way, you'll be on safer ground should a dispute arise.
Um, where is this agreement I signed?
I acknowledge that I have read, understood, and agree to be bound to the terms and conditions set forth in the Customer Agreement as are currently in effect, and as may be amended from time to time.
—Fidelity Investments
Instead of asking you to sign a long contract, a brokerage house typically asks you to sign a nice, short form, usually called an "account application." That's less scary—but guess what? Somewhere near the bottom, the form usually has a clause like the preceding one from Fidelity. It means you're signing a much longer agreement, indirectly.
Sometimes, the agreement is attached. But it may be completely separate—even provided in a way that makes it seem peripheral. Charles Schwab & Co. prints it in a separate brochure. And one Fidelity account bundles the text with other material, in a pamphlet entitled "supplemental information." Since the pamphlet includes the heart of the agreement, that's a bit like calling a car's accelerator and brake "supplemental controls."
This one-two combination is really a way to ease you into signing: You don't skip the main agreement, you simply sidestep it. Nevertheless, your John Hancock says you've read and understood that contract. So be sure you really do.
Can your right to complain outlive the mayfly?
Reports of the execution of orders (confirmations) and statements of account(s) . . . shall be conclusive if not objected to by written notice delivered . . . within ten (10) business days after delivery of or communication of the reports or statement. . . .
—Merrill Lynch
Clauses like this are common. Their message: If you don't protest within the time limit, you're out of luck. But in reality? "That 10-day rule—and it's often three days, especially for confirmation slips—frequently means nothing," says Indianapolis attorney Mark E. Maddox, the immediate past president of the Public Investors Arbitration Bar Association. "Securities disputes are generally decided by looking at the facts of the case, not at an agreement's rigid provisions." That's because the disputes are usually arbitrated, which can work for you, because arbitration permits flexible decisions.
So your real deadline will depend on the facts. Indeed, it might be measured not in days, but in months. For instance, if you failed to review your statements for several months because you put in long hours at your practice and were busy with family and community activities, in a dispute you might be awarded much or all of your loss, says Maddox.
New York securities arbitration attorney Theodore G. Eppenstein provides another example: "Suppose you don't discover you were trading options until your accountant reviews your statements at year-end," he says. "If you understood little or nothing of the trading, the 10-day rule might not matter."
But don't get too relaxed. The underlying principle—do what's reasonable—does matter. If you're simply sloppy when it comes to reviewing communications about your investments, you may indeed lose in a dispute, even against the big, bad brokerage.
Is speed dangerous on the electronic superhighway?
Whether delivered to you by mail, e-mail, or other electronic means, all confirmations, statements, notices and other communications . . . shall be binding upon you, if you do not object, either in writing or via electronic mail, within forty-eight hours after any such document is sent to you. . . .
—Datek Online Brokerage Services
Welcome to e-trading—fast, efficient, and able to zap you with even shorter protest deadlines. But if 10 days is too short, then 48 hours is absurd, right?
Again, that depends. To some experts, such a brief period seems inherently unfair. "I've never heard of a period that short," says Maddox, who doubts that it would be regarded as valid.
However, New York securities attorney David E. Robbins points out that since Datek Online is—as its name indicates—strictly for online trading, this deadline normally applies to records of trades investors are carrying out themselves. "In some circumstances, then, that short period might seem reasonable," he says. "It's not as though you're trying to make sense out of what some broker did." The SEC, in fact, is currently taking a close look at this issue, recognizing that because online trading is different from traditional forms in many ways, the rules involved may have to differ, too.
If they sent it, you got it, even if you didn't
Communications may be sent to the Client at the Client's address or at such other address as the Client gives. . . . All communications so sent . . . will be considered to have been given to the Client personally, upon such sending, whether or not the client actually received them.
—Paine Webber
Notices and other communications may also be provided to you [orally], . . . left for you on your answering machine, or otherwise, [and] shall be deemed to have been delivered to you whether actually received or not.
—Datek Online Brokerage Services
Suppose your broker sends off some incorrect confirmations and statements. They don't reach you, so you can't protest promptly. Later, when you do argue, the broker claims that sending equals receiving. Is that valid?
As you might expect, he's on shaky ground. "Things simply don't work that way in arbitration-land," says broker-arbitration expert Howard Silverman of Bridgewater, CT. True, there may be a legal presumption that messages get to their destinations, but in a brokerage dispute, the facts are examined. So such a clause probably can't be used to prevent you from discussing what actually happened. Nevertheless, brokerage agreements often include such assumptions of receipt.
But when it's you who does the sending, the agreements don't let you make such assumptions. For example, orders to the online service of Morgan Stanley Dean Witter aren't considered received until the brokerage house "has acknowledged that the order has been received." And your notices to A.G. Edwards & Sons concerning discrepancies on statements or confirmations must be made via both telephone and letter.
Why do agreements even include such lopsided provisions? "Because lawyers write these things," says Robbins. In other words: Hey, it can't hurt—throw it in. Such clauses probably keep some customers from making a claim, or even a fuss. But don't let them fool you.
Trading on margin may leave no margin of safety
The firm shall have the right . . . to require additional collateral or the liquidation of any account of the Client . . . without demand for additional margin, [or] other notice of sale or purchase. . . .
—Paine Webber
If your margined stock heads south, says this clause, the brokerage can sell it—or any of your other holdings—to come up with what you owe. Moreover, it can do so without notifying you.
That may sound too harsh to be enforceable, but it's one reason why buying on margin is probably an investor's biggest danger zone. Though tough provisions elsewhere may be mostly posturing, this one is for real, and you'll probably never see an agreement without it. When you invest on margin, you borrow from the brokerage, which means you're partly playing with the brokerage's money. This changes everything—for the broker, too. "If many clients are heavily margined, a firm's own back can be to the wall," notes Robbins. "So when margin's involved, brokerages will be absolutely ruthless, if need be." And because arbitrators understand why such actions happen, they generally decide in favor of firms that take these steps.
Moreover, if you are notified of a margin call, you may have to come up with the cash within hours. Not surprisingly, many experts tell horror tales on the topic, like this one from Maddox concerning a case that's still under arbitration: "The brokerage house sold out my client's account after leaving a message on an answering machine—not the investor's machine, but his brother's." What made this especially infuriating, Maddox says, was that the investor was out trying to wire money to the brokerage house, to cover that margin position. That's why he wasn't home to answer his phone.
So when you're on margin, you may be on thin ice. And watch out if your broker tries to sweet-talk you into feeling safer. Schwab even warns you not to trust any such assurance: "Notwithstanding any oral communications between you and us, we reserve the right to liquidate at any time if the equity in your account falls below Schwab's minimum requirements." Here, "talk is cheap" means talk might cost you plenty.
Can the brokerage simply sing "Don't Blame Me?"
You agree that neither Schwab [nor the companies supplying it with financial data] shall have any liability, contingent or otherwise, for the accuracy, completeness, timeliness or correct sequencing of the Information. . . . In no event will Schwab [or the information providers] be liable to [anyone] for any . . . damages (. . . including lost profits . . .) that result from . . . delay or loss of the use of the [online services]. . . .
—Charles Schwab & Co., online agreement
[Prudential] shall not be liable in connection with the execution, handling, selling, purchasing, exercising or endorsing of puts or calls for my account except for gross negligence or willful misconduct [by Prudential].
—Prudential Securities, option agreement
In online trading and in options, things can move fast. Special agreements that cover such situations often include clauses like these, insisting that the firm is flat-out not responsible for certain matters. Their audacity can go far: Fidelity has language like the Prudential clause, but it doesn't even include exceptions for gross negligence and misconduct. "Such clauses actually state that they're not responsible for the proper operation of the basic services they provide," says arbitration expert Silverman. "But that's not reasonable."
So such disavowals often don't hold up when disputes develop. As Robbins notes, "These are similar to what your parking-lot claim ticket probably says, in trying to avoid damage responsibility for crushed fenders." But legally, responsibility typically goes with the territory, he notes. "A broker offers financial services, and you're entitled to expect that it's making reasonable efforts to ensure that the service is not full of errors."
So the not-my-fault clauses won't be taken literally, though they may have some effect, notes New York arbitration consultant Jerome Olitt. "Such clauses may shift the burden of proof to the investor," he says. "But the facts still will be examined, and arbitrators, more than judges, can ignore technicalities and focus on what's fair and reasonable." Or, as securities attorney Steven L. Miller of Woodland Hills, CA, puts it, "such disclaimers are often absurd. A firm can't hide behind them."
Sometimes brokers' agreements do accept some responsibility. Schwab's, for example, also says, "If we don't complete a transaction to or from your account on time or in the correct amount according to our agreement with you, we may be liable for your losses or damages."
The way you act matters, too
As we've seen, you won't generally be bound by the letter of most brokerage agreements, with the notable exception of clauses about margin. But as the financial expert Bob Dylan once said, "to live outside the law, you must be honest." That applies here: Arbitrators may disregard the specifics of written clauses, but also may not favor you unless you've behaved reasonably. Maybe you can't always check paperwork within hours or even days, but do your best. Make sure your financial profile is accurate and complete (see below). And pay attention: If your broker's actions increase your risk, then object—in writing.
Beyond that, make sure you're comfortable with your broker. "Most of all, you simply want a good relationship with him," says David Robbins. "That will avoid more disputes than any piece of paper. For instance, a brokerage can often grant extra time to meet a margin call; you want to deal with someone who'll do that for you, when possible. That's what to look for."
Writing to your broker can protect you
One element that can be decisive in a dispute isn't even part of the brokerage agreement: It's the information the firm gathers regarding your family situation, income, net worth, and investment goals.
Some firms go way beyond what the SEC requires in this regard. A.G. Edwards' margin agreement, for example, says the firm may obtain an investigative report on you, which, besides credit information, may deal with your "character, general reputation, personal characteristics or mode of living." (The firm says that it will ask your permission before seeking such a report.) Most firms, though, simply supply a few spaces to check off or fill in—range of income and net worth, for instance. And though you'll typically be asked to sign off on the information's accuracy, it may seem a very informal part of setting up your account.
But don't take this lightly. The brokerage is required to gather this information and to heed it in dealing with you. So this has legal consequences, as New York arbitration consultant Jerome Olitt explains: "The broker is obliged to know the customer's overall financial situation and investment goals and to make sure the trading is appropriate." Suppose a doctor-client indicates she's retired, with modest assets, a fixed income, and a very conservative goal—to guard principal. "If a broker brings such a doctor into speculative areas, that would be exposure to inappropriate risk—and if losses occur, that doctor probably has a valid claim against the firm."
Moreover, Olitt adds, both finances and goals must definitely be considered. "A wealthy doctor who could afford very aggressive investments could still have a valid claim if he specified that he wanted only conservative investments," he says. That's important to know—and it's also important to make sure you don't lose that protection. Be as accurate as you can in describing your finances and investment objectives; you don't want to wake up deep in pork-belly futures, unless you know what you're doing.
And beware brokers' games. "I've been a broker myself, and I know plenty of tricks are played with profiles," says securities attorney Steven L. Miller of Woodland Hills, CA. "Often, brokers fill out the form for you. And some will encourage you to exaggerate your financial strength, so the firm's computers will permit the broker to sell you more exciting investments or allow you to invest more on margin if you're short on cash. But if your account runs into trouble, all those inaccuracies or exaggerations protect the broker and the firm."
If the questions about your investment experience and objectives seem sketchy, consider writing a letter to fill in some details. Also write a letter anytime your broker seems to be increasing your risk more than you want, or not contacting you promptly when things change. You needn't be belligerent—just definite and firm, notes arbitration expert Howard Silverman of Bridgewater, CT. "In a dispute, arbitrators have to work with what's brought to them," Silverman says. "The he-said-I-said kind of testimony may not help much, but letters can be a big aid in presenting a winning case."
"You want a record of your investment goals, and of how carefully the broker is heeding them," he adds. "That's what you'd need to show an arbitrator why you should recover your losses."
Securities attorney Mark Maddox agrees. "If you're not interested in speculation or aggressive growth, then say so explicitly in the letter," he advises. "That can protect you a lot."
Silverman's firm, Brokerarb, has a Web site (www.brokerarb.com) with samples of such letters, like the one below. They're designed to be sent when you find your portfolio is heading into riskier territory than you've specified. The letter adopts the honey-beats-vinegar approach, but it shows firmly what the investor intends and how he wants his account handled.
Speaking of letters, advises Olitt, "many firms will send an 'activity letter' saying they hope you're pleased with them, and they hope broker John Doe is working with you well. They often ask you to sign and return it, to assure them of that." That's not courtesy; it's very specific strategy. The firm sends out such letters when its monitoring procedures detect possible problem areas, like "churning" (excessive trading). So it's checking on its brokers—and, at the same time, creating a paper trail showing that you were satisfied with the way your account was being run.
"I advise you never to sign one of these," says Olitt. "It might cost you money someday. I had a client who signed one because his broker said, 'If you don't sign, I won't be able to keep trading your account.' Later, that paper almost lost my client's arbitration case. What saved him was that the panel believed his explanation that he was, in effect, coerced into signing it."
Is that mandatory arbitration clause a problem?
When a dispute occurs, most brokerages invoke a contract clause requiring that you arbitrate instead of going to court. Is that reason to worry? It might be.
Arbitration involves both pluses and minuses, notes arbitration expert Jerome Olitt of Stamford, CT. "There are certainly limitations," he says. "You can't compel discovery as strongly as you can in a lawsuit, so you may not get all the material needed to make your case. Also, arbitrators aren't always expert in all the technical issues of trading, especially specialized areas like option trading."
On the positive side, Olitt adds, the process is informal, typically much faster and cheaper than a lawsuit, and decisions can sidestep legalistic nitpicking. "Also, in some states, you can be awarded attorneys' fees and punitive damages, just as in a lawsuit," he notes.
But what about the larger issue: Arbitrators are often drawn from within the industry—so do they favor the firms? Many experts, even those who typically represent investors, say this is not usually the case. Attorney Theodore G. Eppenstein of New York, for instance, argued for the investor in the 1987 Supreme Court case that decided brokerages could make arbitration mandatory for dispute resolution. Today, even Eppenstein says, "Formerly, the industry-run forums often were perceived as being biased, but you don't hear that sort of comment very often anymore."
However, others, such as New York securities attorney John Lawrence Allen, argue that arbitrators frequently do favor the brokers—especially when it comes to deciding whether to grant an award to an investor. "It's inevitable, given two facts," says Allen. "First, attorneys who request arbitration procedures have a lot of say in choosing who the arbitrators will be. Second, the records of an arbitrator's earlier decisions are readily available, including the size and frequency of awards granted. So arbitrators who often give out big awards know that they may not get as much work."
Unfortunately, you can't delete the arbitration clause from your contract. So keep it in mind, as a spur to create and maintain a strong paper trail concerning your brokerage relationships. That way, in case of a dispute, you'll be able to support your position from your own records.
The Truth About Brokerage Firm's Revenue Sharing
One of the reasons many large fund family funds are not lowering their costs despite steadily increasing assets is the internal cost of what is known in the industry as revenue sharing. Revenue sharing essentially consists of fund companies paying brokerage firms for selling their funds. Pay enough and fund companies can make it onto "preferred" lists which give the fund company's marketers access to branch managers and brokers to help move their merchandise. It's big business; last year, fund companies paid an estimated $2B in revenue sharing. That's over and above sales leads and 12b-1 distribution and marketing expenses. The largest funds are entrenched on these preferred lists so much so that the Securities & Exchange Commission is currently examining the situation to see if more disclosure should be required in regards to these revenue sharing techniques. If brokers are swayed by increased compensation or perks (special trips, golf merchandise, etc.) from certain funds, then shouldn't it be disclosed to investors before they invest? Of course, brokers can sell funds not on their firm's preferred lists but revenue sharing has definitely attracted most brokers' attention. Edward D. Jones, for example, has selling agreements with about 100 fund companies, but the seven that are on its preferred list account for 90% of the firm's $5B annual fund sales according to Cerulli Associates. One industry statistic testifies to the power of the brokerage's preferred lists. Nearly all of the ten largest broker-sold fund families--AIM, Alliance, American Funds, Fidelity, Franklin-Templeton, Kemper, MFS, Oppenheimer, Putnam, and Van Kampen--pay for preferred status at the largest warehouses. Yet only three--Alliance, American Funds, and Van Kampen--rank among Lipper's ten best-performing fund families over the past five years.
Revenue sharing agreements have traditionally covered brokerage firms pushing select mutual fund families. It is becoming more common for brokerage firms to be paid on a revenue sharing basis from other distribution channels such as variable annuities, seperate account-wrap products, and even retirement (401k) platforms. Each channel usually falls under a different unit or division of the brokerage firm, and access to each comes at a seperate price. Caveat Emptor!
Beware Broker's Short-term Bonus Deal
Over the past year, the NASD has fined a number of top independant-contractor type broker/dealers for conflicts of interest in connection with mutual fund sales. The NASD charged 16 firms with violations for giving preferential treatment to certain mutual fund companies - a practice known as directed brokerage.
Of these firms, 15
are retail broker/dealers, and one is a mutual fund distributor, and the fines
totaled more than $34M. In return for paying extra fees to broker/dealers,
these mutual fund companies receive preferential treatment, including higher
visibility on broker/dealer web sites, increase access to firm's sales force,
participation in top producer and training meetings and greater promotion
of their funds than other available funds. Part of the sweep includes the
bonus commission schedules that are being promoted to brokers regarding their
variable annuity sales. Prior violations were mainly from wire house firms,
like Morgan Stanley, or regional broker/dealers like Edward D. Jones &
Company. These are the firms charged with directed brokerage, along with their
fines to date:
Broker/Dealer |
Fine |
Location |
| Royal Alliance Associates, Inc.* | $6,600,000 | New York, NY |
| HD Vest Investment Services | $4,015,000 | Irving, TX |
| Alliance Bernstein Investment Research & Management, Inc. | $3,984,087 | New York, NY |
| Lincoln/Private Ledger Corp. | $3,602,398 | Boston, MA |
| Wells Fargo Investments LLC | $2,970,000 | San Francisco, CA |
| Sun America Securities, Inc. * | $2,500,000 | Phoenix, AZ |
| FSC Securities Corp.* | $2,400,000 | Atlanta, GA |
| Securities America, Inc. | $2,400,000 | Omaha, NE |
| RBC Dain Rauscher, Inc. | $1,700,000 | Minneapolis, MN |
| McDonald Investments, Inc. | $1,500,000 | Cleveland, OH |
| AXA Advisors LLC | $900,000 | New York, NY |
| Sentra Securities Corp.* and Spelman & Co., Inc.* | $780,000 | Phoenix, AZ |
| Advantage Capital Corp.* | $450,000 | Atlanta, GA |
| Advest Inc. | $286,415 | Hartford, CN |
*Wholly owned subsidiary of AIG Advisor Group, Inc. Source: NASD |
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