More On Legal & Compliancefrom The Advisor's Professional Library
- Proxy Voting RIAs are not required to vote proxies on behalf of their clients. However, when an RIA does assume responsibility for voting proxies, the firm’s policies and procedures should help to ensure that votes are cast in the best interest of clients.
- Differences Between State and SEC Regulation of Investment Advisors States may impose licensing or registration requirements on IARs doing business in their jurisdiction, even if the IAR works for an SEC-registered firm. States may investigate and prosecute fraud by any IAR in their jurisdiction, even if the individual works for an SEC-registered firm.
Margin debt at all-time highs is one factor propelling a long-in-the-tooth bull market, now more than five years old.
But while securities lending is a profit center for brokerage firms, it will inevitably pave a primrose path to arbitration and a potentially adverse settlement for brokers involved in the practice.
In a speech last week, Dallas Federal Reserve President Richard Fisher cited record-high margin debt as one indicator of today’s “irrational exuberance,” purposely echoing the phrase made famous by former Fed chairman Alan Greenspan.
Margin lending refers to the loans a brokerage firm will make available to its clients in order to increase the amount of securities they can purchase; the loans are secured by the securities held in the customer’s brokerage account.
Investors accepting such loans are hoping to earn a return on their investments in excess of the margin interest rate they pay the brokerage firm for the loan.
Such transactions can be quite profitable in a bull market like today’s, but in many situations margin loans risk violating FINRA suitability standards obligating brokers to limit transactions only to those in the client’s best interest.
To learn how brokers can protect themselves — and their clients — from future arbitration headaches, ThinkAdvisor reached out to Chicago-based securities attorney Andrew Stoltmann, who represents investors with arbitration claims against their brokers.
Stoltmann has a unique perspective — not only because he has represented some 1,000 claims against brokers since 1999, but because he himself worked as a broker at Merrill Lynch for two years before he went to law school.
“I hated the cold calling, the prospecting,” he says. “I saw a lot of bad things even at a Merrill Lynch that were absolutely incredible. I said to myself I’d rather sue these guys than continue to be one of them.”
ThinkAdvisor: What do you see in the market today that should be of concern to financial advisors?
Stoltmann: I feel like I’m living in the movie "Groundhog Day." It seems that every 10 years we see a massive surge in margin. The last time it really got this bad was the late ’90s before the 2000 market crash.
Brokers just salivate on taking out margin loans for clients in part because the brokerage firms get part of that interest. But it also allows for additional purchases for generating commission and fees.
And for me, as a plaintiff’s lawyer, it’s like shooting fish in a barrel when these brokers recommend margin to many of their clients.
If the client’s over the age of 50; if the client’s retired; if the client has a relatively significant amount of their net worth with that broker, it’s simply going to be an easy suitability claim for me to make when the market tanks 20%.
Would brokers catering to wealthy clients be less vulnerable?
If you have a 47-year-old cardiologist making $700,000 a year and his portfolio has $300,000 worth of margin and he sustains significant losses, I’m not going to take that case, and he’s not going to win the FINRA arbitration.
But if you have a 57-year-old blue-collar factory worker who loses $2,000 in his $5,000 account, it’s going to be very difficult for a broker to explain to an arbitration panel why that’s suitable.
Aren’t brokers in some sense herded by their firm into margin lending? Is it more the broker’s problem or the firm’s problem when it gets to arbitration?
The average client is reading that the market is surging. The broker doesn’t have bad intent, but he wants to magnify those returns. And the client bites off too much risk for him or her to handle. And it becomes the broker’s problem when the market crashes.
Wouldn’t the brokerage firm want to forestall a wave of arbitration claims by preventing unsuitable loans?
The brokerage firms make so much in profits off of those margin loans. The difference between what the firm borrows the money at and what it charges the client — that’s pure profit. You have the firm, the branch managers, the supervisors all kind of burying their head in the sand because the profits to be made are so substantial.
And yet you say it’s the broker’s problem?
Stupidity on the part of the broker isn’t a defense. And yes, the broker doesn’t think it’s going to end badly, but eight times out of 10 it does. Clearly the bonehead broker wasn’t trying to lose his client money. In fact, he was trying to make his client money.
But the suitability rule is pretty stringent, and margin is a red flag from a suitability perspective.
If the broker is still with the firm, usually the brokerage firm will pick up the tab. If the broker leaves the firm and the firm is named, they will often go after the broker for the amount they have to pay.
It depends on the relationship between the broker and his firm. If he’s a big producer and they want to keep him happy, they’ll pay it. If he’s a small producer, and a complainer, they may make him pay the freight.
Is your business really based on “irrational exuberance,” with lulls between the market spikes?
It is. My business is very cyclical. Once the market crashes, I’m swamped for about five years. Then it slows down, the bubble reinflates, bursts, then I’m swamped for another 5 years.
Brokers and brokerage firms never learn their lesson. It’s greed more than anything else.
If these arbitration claims are like a scene out of "Groundhog Day," where are the regulators in all this?
You have an impotent regulator in FINRA and in the SEC, a truly toothless tiger. Nobody fears these guys. There’s no real regulation in part because of the political influence the securities industry has over the SEC.
JPMorgan, Goldman Sachs, the major banks and brokerage firms are major contributors even to Obama. No other industry can get away with what they get away with.
The limited regulation, minimal congressional oversight and greed become a toxic brew of problems, and the investor gets left holding the bag.
The good news is it’s allowed me to make a very good living for myself. But it’s still sad.