[Updated through 2020] Many of stockbroker fraud cases we see involve alternative investments – Real Estate Investment Trusts (REITs), Tenants in Common investments (TICs), private placements and complex derivative securities. In our experience, these investments are more prone to fraud and have problems because they are often thinly traded.
Just 20 years ago, the types of investments commonly available to investors were quite limited. Stockbrokers generally peddled stocks, bonds and the occasional options strategy. Over the last several years, however, the sheer number of investment vehicles available is huge. Everyday a new derivative is invented and quickly brought to market. Unfortunately, today that means stockbrokers often don’t understand the intricacies (or even the basics) of the investments they are offering. Private placement memorandums, prospectus documents and offering documents are often hundreds of pages in length.
When the investment adviser or broker selling these investments doesn’t understand them, the investor often suffers. Without fully understanding the risk factors involved, financial professionals can’t perform any meaningful due diligence. They also can’t properly determine if they are suitable for their customer’s needs.
Real Estate Investment Trusts – REITs
Another example of stockbroker fraud is the sale of thinly traded REITs. “Thinly traded” means there is no ready secondary market for the investment. That means investors might have to hold on to their investment for a decade or longer. While that might be fine for a younger investor with no need to access their monies, elderly investors who need their investments to fund retirement are at risk.
Complex Derivative Securities
One of the newest products on the market are complex derivative securities. This is a security whose price is based upon or derived from one or more underlying assets. These products are usually Most derivatives highly leveraged, highly volatile and carry high commissions. (In fact most of the alternative investments listed in this post have high commissions which is why stockbrokers love them.)
Common derivative securities products include reverse convertibles and principal protected notes or enhanced notes. Don’t let the term “principal protected” fool you.
The aura of safety evoked by the term “principal protected” makes it easy for greedy stockbrokers to sell these investments to clients. Unfortunately they often result in big losses for customers who pay high commissions, high management fees, may receive little or no interest, and could be required to wait a decade just to get their money back. And that brings up the another problem, lack of liquidity.
Alternatives Are Often Illiquid and Thinly Traded
Have 100 shares of GM stock? Those shares can be liquidated in literally a nanosecond. But complex derivative securities and other alternatives often don’t have a ready market meaning they are hard to sell (“thinly traded). We have seen many instances of customers suing their brokers when they learn that they can’t sell or redeem their investment. Brokers must be extremely careful when recommending thinly traded investments. Several firms have been heavily fined by the Financial Industry Regulatory Authority (FINRA) for recommending thinly or not-traded real estate investments.
FINRA fined LPL Financial $950,000 for improperly recommending non-traded REITs. Several customers complained when they learned they could not sell their investment. It’s nice to get a monthly statement saying your investment is worth $1 million but that statement is just a piece of paper. If the investment can’t be sold because there is no market, sone would argue the investment is worth nothing.
FINRA and the SEC have been warning the industry for several years to be careful when recommending alternative investments, particularly those that have no secondary market. As a result from on-going regulatory pressure and the recent fine against LPL, several broker dealers have announced new restrictions on the sale of these investments.
Some firms are now restricting how much of a customer’s portfolio should contain these alternatives. (Customers are always free to buy whatever they want, however the new guidelines restrict what and how much should be recommended to clients.) Other firms are beefing up their due diligence efforts to insure that brokers fully understand the investments they are recommending and to insure that the investment isn’t a scam.
Over the last 18 months, several broker dealers have gone under after getting hit with multiple stockbroker fraud claims stemming from sales of an alternate Tenant in Common scheme. One a small broker pushes its brokers to all sell the same derivative or alternative investment it is usually for the commissions. Watch out. When everyone sues the brokerage firm, often only the first few folks in line get paid.
Stockbrokers Are Responsible for Bad Investment Advice
Investment advisers and stockbrokers can be held responsible for making unsuitable recommendations, for not fully understanding their customers’ cash flow needs and risk tolerance and for not performing due diligence on the products they offer. Unfortunately, when the broker dealer goes out of business, their clients may be stuck with no recovery.
Stockbroker fraud is a serious problem and takes many shapes and forms. The decision to scale back on alternatives, especially for the elderly, is a good one. Thus far just a handful of brokers have agreed to voluntarily impose internal controls. We hope other brokers do so as well.
Unlike investment advisers, stockbrokers frequently get paid by commission. While traditional investments might only carry a 1 or 2% commission, alternatives can pay 7 to 10%.
Selling Away and Complex Derivatives
As many states begin restricting the quantity (“concentration limits)” and types of alternatives and complex derivative securities they can recommend, the lure of huge commissions has caused some to engage in “selling away”. That is the practice of selling investments without their employer’s knowledge. Purchasing from a broker who is selling away may prevent the customer from suing the broker dealer, particularly if the customer knew that his or her broker was working these “side deals.”
As more brokerage firms begin to regulate alternative investments, we expect to see an increase in selling away stockbroker fraud cases.
Complex Derivative Securities Fraud and Elderly
Alternative investments and complex derivative securities are generally not suitable for the elderly, retirees and anyone who is looking to preserve their capital or needs ready access to their savings. While they may be great for institutional investors or high net worth folks willing to speculate with a portion of their portfolio, they just aren’t suitable for most of us. That hasn’t stopped stockbrokers from recommending them, however.
Protecting Your Nest Egg
Our advice? Alternative investments and complex derivative securities can be a great way to make above market rate returns and capital appreciation. If approached by a stockbroker offering such an investment, inquire as to his or her commission, make sure you understand the fine print, make sure your broker fully understands the investment and determine whether an employee of the brokerage firm has conducted extensive due diligence on the product. In other words, make sure that the investments have been well vetted and aren’t simply being offered because they carry a huge commission.
Also make sure that your adviser is working through a legitimate broker dealer and not “selling away.”
Stockbroker fraud occurs daily across the United States. Sometimes the broker is solely to blame and at other times its both the broker and a dishonest promoter. Either way, it is the customers that ultimately suffer.
If you believe you are the victim of stockbroker fraud, contact us immediately. Most stockbroker fraud cases can be handled on a continent fee basis and can often be handled through arbitration, a quick way to resolve cases. For more information, contact attorney Brian Mahany online, by email or by telephone at (202) 800-9791.
Mahany Law – America’s Stockbroker Fraud Lawyers. Services available nationwide.
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