FINRA: Exposing the "Bad" Brokers

The Financial Industry Regulatory Authority (FINRA), which is the arbitration forum that handles virtually every customer/broker dispute, has proposed an expansion of its free BrokerCheck disclosure system. See FINRA's news release here.

BrokerCheck is a free on-line service that FINRA provides to investors to research their brokerage firms and investment advisors for past regulatory infractions.  It is an invaluable resource in helping investors judge whether or not to conduct business with a particular brokerage firm or investment advisor.  

At this time, the FINRA BrokerCheck system temporarily discloses information about investment advisors who have left the industry (often involuntarily), but it only discloses that information for up to two years after the advisor's departure. FINRA's proposed changes would allow BrokerCheck to disclose information for up to 10 years, and in some cases permanently.

In the news release, FINRA Chairman and CEO Rick Ketchum states that "recent regulatory and criminal proceedings in the financial services sector reveal that former brokers have been engaging in fraud and other misconduct long after establishing themselves in other segments of the financial services industry."  Since these "bad" brokers can still cause great harm to the investing public, FINRA wishes to help investors identify them by keeping their infraction and termination records public for as long as possible, and to make certain information available permanently, such as criminal convictions and certain civil and arbitration judgments.

These expansions to the information disclosed by BrokerCheck are helpful, and they are a move in the right direction.  However, I would also recommend another type of expansion regarding the information disclosed.  In many cases, a broker may have additional complaints on his record with state regulators and the SEC, but these are not typically disclosed in the FINRA BrokerCheck reports.  Therefore, it would be advantageous to request that state regulators and the SEC report any complaints and infractions to the FINRA BrokerCheck system, so that this information will also be available to investors when they are evaluating the disclosure record of their investment advisors via the BrokerCheck system.  

Another area of concern is the current practice in securities litigation where a plaintiff attorney avoids naming the investment advisor in a customer dispute in order to facilitate the future settlement of the arbitration case.  The trend has developed because it typically provides no legal benefit to name the investment advisor.  The approach is often seen as less adversarial and friendlier by the respondent brokerage firm, which ultimately benefits the claimant in terms of easing future settlements negotiations.  However, while it does make the settlement process smoother and easier for both sides, the unfortunate result is that a "bad" investment advisor can commit infractions that result in lawsuits without gaining any bad marks on his or her record.  Since the "bad" advisor was not a named party in the action, nothing will be disclosed on the advisor's BrokerCheck report, and the advisor will appear to have a perfectly clean background.  In order to avoid this kind of situation, FINRA should disclose whether or not an investment advisor committed an infraction that resulted in a lawsuit regardless of whether the advisor was merely acting in the course and scope of his or her employment, and regardless of whether the advisor was named as a respondent in the action.

Reverse Convertible Nest-Egg Slashers

Reverse convertible bonds are highly complex and highly speculative investments. Notwithstanding a typical investor’s lack of sophistication, even experienced investors do not commonly know what they are buying when they purchase a reverse convertible bond. For this reason, reverse convertible bonds are also referred to as “Nest Egg Slashers,” a term first coined in the Wall Street Journal when referencing this high-risk investment.

When an investor purchases a reverse convertible bond, the investor is essentially giving an unsecured loan to a financial institution while at the same time writing an out-of-the-money put option on a corporate individual stock. Reverse convertible bonds are often described as short-term, unsecured bonds issued by banks and/or highly-leveraged financial institutions. Typically, they are linked to the performance of a stock and pay higher yields than the average fixed income investment. Once the bonds mature, the investor is supposed to get his or her full principal back; however, if the value of the underlying stock falls below a specific level, called the ”knock-in” level, then the shares get converted into shares of the devalued stock, which the investor receives in lieu of his or her initial investment.

Prior to the stock market downturn of 2008 and 2009, reverse convertible sales increased markedly, and nearly doubled in 2006 and 2007. Recently, news reports have suggested that some brokerage firms targeted senior citizens and other conservative, risk-averse investors in their efforts to sell reverse convertible bonds. Reverse convertible bonds were often misrepresented as safe, income generating investments suitable for retirees.

Unfortunately, when the stock market declined in 2008 and 2009, reverse convertible investors suffered massive financial losses.

Sometimes an investment advisor will misrepresent and/or omit material facts from his or her clients regarding the safety of their reverse convertible bonds. In fact, the advisor might even tell the investor that the reverse convertible bonds will help to preserve the investor’s retirement principal while generating a safe and reliable income. However, since reverse convertible “Nest Egg Slashers” are tied to the performance of stocks, they do not provide any kind of safety or protection from stock market volatility.

In my legal writing business, Strategic Legal Writing, I have assisted attorneys in rectifying some of the damages wrought upon investors who purchased reverse convertible bonds. Having witnessed their devastating affects, it is my opinion that the higher yields on these ‘designer’ investments are not worth the risks assumed by the investors who purchase them.