NEW YORK – In the wake of the stock market collapse, angry investors across the USA are filing complaints and arbitration claims against their stockbrokers, blaming them for losses that in some cases wiped out retirement nest eggs.
The surge in complaints is not restricted to small, fly-by-night brokerage firms, but also involves large companies. And the allegations of broker misconduct have less to do with hyping little-known penny stocks than with charging exorbitant fees, buying stocks on margin and recommending unsuitable investments, especially high-tech stocks.
“I think we’ll find that the bull market masked many sins,” says Indiana Securities Commissioner Brad Skolnik. “If, for example, a broker advised a customer to put a modest life savings in high-risk technology stocks, there may be a problem.”
Eugene Mandell, a teacher in Ashland, Ore., admits he doesn’t know much about investing. In February 2000, he transferred much of his savings to two Dean Witter brokers who, he says, assured him that they had the stock-picking expertise to enhance his returns. Mandell, 51, says he told the brokers that he wanted a moderately conservative investing approach.
But he says the brokers invested most of the money in volatile high-tech stocks. Mandell, who is married and has four children ages 10 to 19, says that last summer and fall, when the losses started to mount, he became alarmed. “They would consistently say, ‘Don’t worry, there will be a market comeback.’ “
“I’m not a risk-taker,” he says. “But I could have taken the money and gone to Las Vegas and maybe done better.”
Early this year, he hired a New York-based securities lawyer, John Lawrence Allen, to represent him in an arbitration case. Morgan Stanley Dean Witter, which renamed its broker dealer offices Morgan Stanley DW in April, says it does not comment on individual clients.
Most brokerage account agreements require disputes to be settled through arbitration. Allen, who is preparing to file the claim, says Mandell lost about $150,000, more than half of what he invested.
“This is a nest egg that I’d been building over the past 25 to 30 years,” Mandell says. “It’s a substantial financial hit, and it has emotionally devastated our family.”
In the first quarter, the number of arbitration cases submitted to the National Association of Securities Dealers (NASD), the largest securities dispute resolution forum, increased 15%. The claims are on track to reach 6,224 this year, a 12-year high.
Inexperience on both sides
It’s not surprising to see broker complaints rise when the stock market stumbles. But a combination of factors – an upsurge in novice investors and an increase in inexperienced brokers – seems to be adding fuel to the fire.
The stock market went up for so long that many conservative investors who had been sitting on the sidelines finally decided it was safe to take the plunge. They often got into the market at the worst time – at or near the very top – and many let brokers convince them that technology stocks were the way to go.
It was not unusual for these novices to have substantial amounts of money to invest. “We’re seeing first-time investors with million-dollar accounts,” says Rosemary Shockman, an investor attorney in Scottsdale, Ariz. “Now they have million-dollar losses.”
Many of the brokers were just as green as their clients. The number of SEC-registered representatives in the USA has increased from 506,000 in 1995 to 677,000 today, according to the NASD – a 34% increase. In some states, the increase has been more dramatic. Skolnik says the number of licensed brokers operating in Indiana has more than doubled in the past 6 years, from about 45,000 to more than 100,000. “Many Young Turks have never been through a declining market,” he says.
The young brokers were not just inexperienced, but often also poorly supervised, investor advocates say.
It is not common for customers to give brokers formal power of attorney to make trades on their behalf – called discretionary authority. “Many firms discourage it or don’t allow it because there is a higher standard of care and more exposure to liability,” says Tracy Pride Stoneman, a securities lawyer from Colorado Springs.
But more often, neophyte investors don’t understand their rights and don’t question brokers who make trades without advising them first. “I’m amazed at how many investors don’t know that a broker should check with them before making a trade,” Stoneman says.
Stoneman says that Jan Herrmann is typical of these inexperienced investors. Herrmann, 46, lives in Salida, a small town in southwest Colorado, and works at a J.C. Penney automotive center. In 1996, after she inherited nearly $200,000 from her mother, she decided to invest it with a broker at Raymond James. “My parents worked real hard to earn that money and to be able to leave their children a nice share of it,” she says.
The money had been invested in mutual funds, and Herrmann says she told the broker, Mort Forney, that she was comfortable with that. “I said I wouldn’t mind making some money, but I want to be conservative,” she recalls saying.
Eventually, she says, he started investing Herrmann’s money in technology stocks. He didn’t discuss the trades with her, she says. Instead, she says he would sometimes call her husband, even though the account was in her name only.
Herrmann claims that before she knew what was happening, the broker was borrowing money from the firm for her to buy more stocks on margin. “I didn’t know what margin was,” she says. When the market began to tumble, the margin debt only caused her losses to snowball.
As Herrmann saw her account balance dwindle, she became despondent. “I thought we were screwed,” she says. When she found out she could file an arbitration claim, she hired Stoneman to represent her. According to the statement of claim, Herrmann paid $23,000 in commissions and $33,494 in margin interest. She is seeking $266,000 in damages.
In calculating that amount, Stoneman looked not just at the losses, but at what Herrmann would have earned if the money had been suitably invested. An expert witness determined that a portfolio with 75% invested in a Standard & Poor’s 500 index fund and 25% invested in a U.S. government long-term bond fund would have been appropriate, then used those returns to estimate the damages.
Forney declined to comment. And Raymond James does not comment on ongoing arbitration cases, spokesman Lawrence Silver says. “But if we felt a client was wronged, our policy is to rectify errors,” he says. “We don’t want to lose a client.”
No one likes to lose money, and there are plenty of angry investors looking for someone to blame. But when do a broker’s recommendations rise above bad advice and become misconduct?
To have a shot at winning an arbitration dispute, “There must be something more to the claim than the fact that your portfolio is worth less today than it was a year ago,” says Linda Fienberg, president of NASD Dispute Resolution.
And you also won’t have much of a case if your broker violated the rules, but you still made money. “Cases result from damages,” says Philip Aidikoff, a securities lawyer in Beverly Hills.
There are many types of prohibited conduct. Among them: misrepresenting or failing to disclose material facts about an investment and recommending securities that are unsuitable given a customer’s age, financial situation, investment objective and investment experience. Firms can be held accountable for failing to supervise a broker.
The Securities and Exchange Commission says that in the first 3 months of the year, complaints about broker sales practices moved to the top of its list of grievances. For example, it received 254 complaints about brokers who allegedly misrepresented investments, up from 200 in the same period last year.
Misrepresentations and unauthorized transactions by brokers were the top two complaints in the first quarter. By contrast, last year’s complaint list was dominated by administrative problems related to online trading.
The SEC uses complaints to look for patterns of misconduct. But it doesn’t intervene on behalf of individual investors. “We don’t have the authority or power to force a firm to make it right,” says Susan Wyderko, director of the office of investor education. The SEC forwards complaints to the brokerage firms and asks them to respond in writing.
Likewise, state securities regulators don’t represent individual investors. They rely on investor complaints to alert them to misconduct. “We can pull licenses or put brokers in jail if they are guilty of criminal violations,” says Fred Joseph, Colorado Securities Commissioner.
When a small amount of money is involved, investors may be able to resolve complaints directly with the brokerage firm, experts say. But if investors believe that broker misconduct has caused them to lose substantial amounts of money, they should consult a lawyer, says Fienberg.
Not surprisingly, securities lawyers say they have been flooded with calls from irate investors in recent months. Complaints frequently have two common themes: margin debt and an overconcentration in tech stocks. But the two do not always make a strong case.
If clients wanted to invest in high tech or to invest on margin to make more money, they are probably on the hook for losses, experts say. “Or say a broker recommended bad stocks,” Shockman says. “As long as they were reasonable under the circumstances, they don’t have to be right.”
When a broker persuades an older, inexperienced or conservative client to invest all or most of his or her money in risky stocks or to buy stocks on margin, that should raise a red flag, regulators and industry experts say.
Still, arbitration cases involving claims of misrepresentation and unsuitable investments can be difficult to sort out. They may come down to the broker’s word against the investor’s. And often the brokers have no history of misconduct.
Cynthia McNamara, 51, a Realtor, and her mother, Patricia, 77, an interior decorator, from Pasadena, Calif., filed an arbitration claim against Merrill Lynch. Among other things, the complaint alleges that their broker liquidated conservative holdings, such as Berkshire Hathaway stock, and, despite their ages and conservative investment history, concentrated their assets in speculative technology stocks and borrowed money on margin to make the purchases.
Their claim also alleges that the broker, Robert Morgart, traded the accounts excessively, generating big commissions. For example, Cynthia’s account had a turnover rate of 4.85 times per year through December 2000, the claim says. That meant her account would have needed a 15.9% annual return to recoup trading expenses.
The McNamaras suffered $632,000 in out-of-pocket losses, not including the amount they would have earned if their money had been suitably invested, their lawyer, Philip Aidikoff, says.
Morgart did not return calls for comment. Merrill Lynch declined to comment on the specifics of the case except to say that the charges “are totally false and will be refuted at the proper time and place.”
The McNamaras say most of their savings has been eaten up by margin debt and trading losses. Patricia, a widow, has taken out a home equity loan to pay their bills. She also has deferred her retirement in order to supplement her Social Security. Merrill Lynch says the mother and daughter owe the firm about $8,500 due to losses on margin trading.
“If you had asked me what margin was a year ago, I didn’t know,” Cynthia says. “Now I know, but everything is gone.”
There are two main forums for securities arbitration cases: NASD Dispute Resolution and the New York Stock Exchange. At the NASD, it takes 12 months on average to complete a case. Claims of $25,000 or less generally don’t take as long because they do not require a hearing. Claims of more than $100,000 usually require a hearing before a three-arbitrator panel.
Carol Tomasetti was a nervous wreck when she went before an NASD arbitration panel. “They brought in expert witnesses,” she said, referring to the lawyers for the brokerage firm that she filed a claim against, American Municipal Securities of St. Petersburg, Fla. “I came out and thought I’d have to file for bankruptcy.”
Tomasetti, a customer service representative from Tarpon Springs, Fla., initially invested about $300,000 inherited from her father with John Lewis, a broker at the firm. Between March 1997 and March 1998, the account plummeted in value to about $100,000. Upset, she asked her accountant to take a look at her brokerage account statements, and he discovered that there had been a lot of trading.
Tomasetti’s lawyer, Allan Fedor, calculated that she would have had to earn 23% on her investments just to recoup trading commissions. “The broker made 370 trades in roughly a year,” Fedor says.
On Jan. 30, about 13 months after her claim was filed, the arbitration panel awarded Tomasetti about $95,000 plus attorney fees. The brokerage, which fired her broker, believes it got a bum rap. “Our position was that the customer was very much aware of the issues and accepted the risk of what she was doing,” says John Petagna, president of American Municipal Securities. Lewis declined to comment.
Tomasetti didn’t get nearly the $470,000 that her lawyer had sought in damages from the firm. Still, she says, “I feel good just because I won.”