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
- 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
- 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
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
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
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
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)
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:
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:
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
or by calling (202) 737-0900.
Non-US Regulators and Exchanges
International Organization of
Securities Commissions (IOSCO)
Australian Securities and Investment Commission (ASIC):
Ontario Securities Commission (OSC):
Commission des Valeurs Mobilieres de Quebec (CVMQ):
British Columbia Securities Commission (BCSC):
Toronto Stock Exchange (TSE):
Commission des Operations de Bourse (COB):
Bundesaufsichtsamt fur den Wertpapierhandel (BAWe):
Bundesaufsichtsamt fur das Kreditwesen (BAKred):
Commissione Nazionale per le Societa a la Borsa (CONSOB):
Financial Services Authority (FSA):
Securities and Futures Authority Limited (SFA):
Investment Management Regulatory Organization (IMRO):
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
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
toward 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
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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
"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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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
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.
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,
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. . . .
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
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
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.
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
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. . . .
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
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
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
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
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
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
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
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
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!
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
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:
|Royal Alliance Associates, Inc.*
||New York, NY
|HD Vest Investment Services
|Alliance Bernstein Investment Research & Management, Inc.
||New York, NY
|Lincoln/Private Ledger Corp.
|Wells Fargo Investments LLC
||San Francisco, CA
|Sun America Securities, Inc. *
|FSC Securities Corp.*
|Securities America, Inc.
|RBC Dain Rauscher, Inc.
|McDonald Investments, Inc.
|AXA Advisors LLC
||New York, NY
|Sentra Securities Corp.* and Spelman & Co., Inc.*
|Advantage Capital Corp.*
|*Wholly owned subsidiary of AIG Advisor