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Sue Your Broker

10/1/2001

Money Magazine

WHEN OVERZEALOUS BROKERS MET NEWLY MINTED INVESTORS IN THE LONG BULL MARKET, FORTUNES WERE MADE AND LOST IN AN INSTANT. NOW EVERYONE’S POINTING FINGERS OVER THE MISSING MONEY.

Since stocks peaked in March of last year, investors in the U.S. market have lost $4 trillion in paper wealth. That’s an awful lot of money, and it’s left an awful lot of people pissed off–and looking for someone to blame.
Their targets: brokers and financial advisers. Across the country, investors are filing claims in record numbers. In the first seven months of this year, arbitration claims with the National Association of Securities Dealers, the primary forum for these cases, soared 25% from the same period a year ago, to 3,950, nearly double the amount filed in 1990. Less formal complaints to the Securities and Exchange Commission jumped to 27,920 in 2000, a 58% increase from 1995.

The total dollars claimed are rising too. The average case against a top 10 brokerage that completed arbitration surpassed $500,000 last year, compared with $370,000 five years earlier. “Million-dollar complaints are increasingly common,” notes Beverly Hills attorney Phil Aidikoff. Confirms insurance executive Kathy Jacobson at the Seabury & Smith unit of Marsh & McLennan: There is a “very substantial” rise in negligence claims and payouts, affecting brokerages large and small. And if all that isn’t enough, there’s more:

–In the first seven months of this year, more than 100 class-action securities suits were filed alleging abuses by brokerages in their allocations of IPOs, according to Stanford Law School’s Securities Class-Action Clearinghouse.

–For the first time, legal complaints have been filed against stock analysts at brokerages over their potentially conflicted advice. In July, Merrill Lynch agreed to pay $400,000 to settle an arbitration case that, among other things, blamed Internet poster-boy analyst Henry Blodget for losses. While Merrill notes that the claims against Blodget were dropped, class-action suits with similar allegations have since been filed against analyst Jack Grubman, Salomon Smith Barney’s telecom guru. Six suits against Mary Meeker, Morgan Stanley’s so-called Queen of the Net, were dismissed in late August.

–In one of the biggest class-action lawsuits of its kind so far, plaintiffs allege that six major brokerages required their analysts to issue positive recommendations on certain Internet stocks in order to get investment banking business for the firms and never disclosed that fact to the public. Those recommendations, the suit charges, led to investors’ losses on the overhyped securities.

–Meanwhile, lawyers are drumming up business with a vengeance. Websites like investorfraud.com, Justice4investors .com and Stocklawyer.com tell searchers to, as one of the sites puts it, “Click here if you seek the return of your money.” TV, radio and newspaper ads are multiplying. Richard Stephens, a Boca Raton, Fla. attorney who runs Stocklawyer.com, says he’s gotten scores of phone calls from angry investors since he started advertising on CNBC.

What’s going on here? Have brokers really gone over the edge? Or is our tolerance for the ways of Wall Street simply running out? Clearly, some of the legal activity is garden-variety claims, from nuisance suits seeking to tap into the big brokerages’ deep pockets to classic churning scams by unscrupulous salespeople. But a large number of claims appear to be something new: fallout from the explosive mix of inexperienced investors and overly confident brokers in a stock market where everyone, it seemed, was making easy money. Until suddenly they weren’t. As Vincent DiCarlo, a former securities regulator who now represents investors filing these cases, puts it, “At the end of a long bull market, you’re scraping the bottom of the barrel on both sides.”

We’ve spoken with scores of investors and their attorneys, as well as major brokerages, and looked at several dozen large claims in detail. While some of the complaints are compelling, what’s really astounding is the extent to which some investors abdicated responsibility for their accounts–signing documents without filling them out, not opening monthly or quarterly account statements, remaining ignorant of basic margin rules even as their own margin debt ballooned. Equally astounding, on the other side, is how little many of these brokers–even those at the top-name firms–seemed to focus on their clients’ financial goals and long-term well-being, and how easily all concerned were swayed by bull market bravado to load up portfolios with pricey tech stocks, day-trade with abandon and rely on dangerously leveraged margin accounts.

This is not a black-and-white situation of victims and victimizers. Instead, it’s a tale of how communication between investors and advisers broke down during the Great Bull Market and how history is being revised by both sides even as we speak. In one corner are brokers who gave clients poor advice and made money at their expense; in another are investors who came down with their own get-rich madness. Fanning the claims are lawyers who see potentially huge payouts in these disputes–and so are pitting the two sides against each other in record numbers.

zealous brokers

Lawyers who want to argue that brokers ran amok during the bull market can point to some compelling cases. Consider the troubles at the Flushing, N.Y. office of PaineWebber (now UBS PaineWebber), which opened in early 1998, as Wall Street firms raced to launch new branches in long-ignored Asian communities. PaineWebber made quick headway in this heavily Korean neighborhood, printing brochures in Korean and hiring bilingual brokers. But now, in a series of pending and settled claims, 13 investors say they got fleeced by three of the branch’s brokers (all of whom have since left the firm and are no longer employed in the industry). One claim: that the account of Yong Ho Lee, 27, his brother, Joung Ho Lee, a 28-year-old quadriplegic, and their widowed mother, Seung Ja Chang, was traded so heavily that they paid out 35% of their average equity in fees and commissions, at a cost of some $100,000. Another pair of brothers, the Kangs, claim they paid $720,000 in commissions, fees and interest on margin loans on a million-dollar inheritance. The investors’ attorney, Christine Bae, says five of the original 13 investors have settled, while at least 15 more have come forward to file new claims. UBS PaineWebber confirms that it has settled an unspecified number of claims and that it remains in discussions on the rest. “We will do what is right for those clients,” says a spokesman. (The Flushing branch closed in May.)

Other examples abound. In California, Kevin Guertin, 40, a former store manager at Home Depot, entrusted a $500,000 portfolio he’d accumulated through employee stock options to Legg Mason. Guertin alleges in a pending arbitration that his broker (who no longer works in the industry) reduced the account to zero through day-trading and bad margin bets. “I didn’t realize the losses until the very end, when I had three inches of confirmation statements for the year,” says Guertin, who now works for a trucking firm. (Legg Mason declined to comment.)

In suburban Detroit, David Cheslin, 43, who made a bundle selling his General Motors dealership, is suing his broker over the loss of that windfall. In February 1999, according to the pending claim, Cheslin–who says he had never traded stocks before–deposited $600,000 with McDonald Investments; by this past April, the account had fallen nearly 97%, and Cheslin bailed with the remaining $20,000. In the claim, he alleges that the account was overconcentrated in tech and Internet stocks, loaded up on margin and traded heavily. “It got uncontrollable,” Cheslin says. (McDonald declined to comment.)

These types of allegations illuminate the worst fears of the investing public: that trusted brokers know or care little about what’s in the best interest of their clients. Brokers are prohibited by law from trading excessively to generate higher commissions or misrepresenting an investment as a “sure thing.” They’re also required to know their clients’ risk tolerance and financial needs, and to keep an eye on whether their accounts fit within those limits. In theory, brokers at major firms are kept in line by branch managers, who, in turn, are watched by a firm’s central compliance apparatus. If a broker churns an account or puts an 85-year-old retiree 85% in dotcom stocks, the firm ought to catch it–and stop it.

But with the investing explosion of the 1990s, plaintiffs’ lawyers assert, the compliance operations at brokerages began to buckle. Over the past decade, the number of brokers and support staff has surged 86%, to about 775,000, according to the Securities Industry Association. These brokers are also spread out in more offices, and each is handling more accounts, more assets per account, more complex services like margin loans and much, much more daily trading volume. “There just aren’t enough qualified people to supervise,” says David Tilkin, a former manager for First Union and Smith Barney who now sells compliance software called Broker- Audit to Wall Street firms.

Executives at major brokerages take some exception to this line of reasoning (although none of the large firms contacted by MONEY would discuss the broader compliance issues on the record). Over the past decade, advances in technology have made automatic, remote oversight of brokers simpler and more efficient. Meantime, training requirements by brokerages have been beefed up, and many larger players have moved away from commissions and instead charge a fee based on assets under management. “The firms are much more careful,” insists David Boch, an attorney at Bingham Dana in Boston, which represents brokerages. “I would not ascribe the increase in claims to bad practices by the brokerage firms.”

Still, to meet customer demand as the long bull market persisted, brokerages had to hire some younger and less experienced brokers. Certainly, as the ’90s ended, there were more brokers and advisers in the field who’d never been through a sustained downturn and truly believed the this-time-things-will-be-different line. “In rising markets, firms tend to be somewhat more permissive about the caliber of brokers they hire,” explains Arthur Levitt, former chairman of the SEC. “The market goes down, and you see more complaints. In a market downturn, firms tend to let go of marginal brokers, to fire them and to tighten up on their compliance procedures because these problems surface when customers have lost money.”

naive investors

But now comes the question: Where do you draw the line of responsibility between investors and their hired hands?

The explosion in the number of investors–about half of all American households own equities directly or indirectly–has meant a growing number of naive investors with increasingly large portfolios. A recent survey by the Securities Investor Protection Corporation and the National Association of Investors Corporation found that only a small minority of people knew there was no insurance for stock losses. “Bless their hearts, people are calling because they don’t understand how they lost so much so quick,” says investors attorney Adam Doner of Palm Beach, Fla.

If brokers were greedy, so too were investors. And if brokers were willing to bet it all on tech, well, so too were investors. “If a customer says, ‘I want to buy all tech stocks,’ he has to understand his obligations and his risk,” argues brokerage industry attorney Boch.

When the market was booming, few of these investors complained that their accounts were heavily traded or cared about ballooning margin balances, even though such risky leverage rarely makes sense for average folks. Too many people simply looked with glee at the last line on their account statements. Remember former Legg Mason client Guertin, whose $500,000 portfolio was squandered? He acknowledges that he didn’t understand the details of his account statements until the end of the year. And, he admits, “when we signed the [new account] forms in the very beginning, I left them blank.” Observes Jim Cox, a professor of securities law at Duke University: “Investors have to step up and assume more responsibility.”

Time for a case study: Madelyn “Mady” Shibe vs. Prudential Securities and broker Larry Mayer. To hear Shibe tell it, she was once so delighted with Mayer that she gave him a gift certificate for a pair of Gucci shoes. By catching the tech craze and buying stocks with margin loans, Shibe’s $350,000 account rocketed to $3.5 million. But that was just before tech stocks collapsed and Shibe’s account fell straight back to $350,000. These days she has the fury of an investor scorned. The 74-year-old widow recently filed a complaint against her former brokerage for giving her bad advice, loading her with margin debt and overconcentrating her portfolio in too-risky tech stocks (including Cisco, Lucent and JDS Uniphase) that have since tanked. She’s mad, she says, because her concerns about the account’s downward slide were brushed off. Compensatory and punitive damages claimed: $11.7 million, plus interest and attorney’s fees. “I didn’t know anything about the stock market,” Shibe wails over the phone from her Lauderhill, Fla. home. “I just had my trust in Larry, and there was no reason not to.”

What does Prudential say to all this? While the firm declined to make Mayer available for comment, it argues that Shibe’s claim is without merit–and it plans to fight her all the way. “We recommended that the client take profits,” says a spokeswoman for Prudential. “The claim does not mention that she took money out of the account and that the account was profitable.”

So who’s to blame for Mady Shibe’s roller-coaster ride? Her broker? Shibe herself? The market? Or is this just the kind of thing that happens sometimes when you invest in stocks?

“This was complete mismanagement of her account and greed on the part of her brokers,” insists Plantation, Fla. attorney Darren Blum, who is representing Shibe in her claim. “This account should have set off red flags in the office.” Blum, of course, has his own agenda in this blame game. In fact, his firm currently has about 75 cases pending against brokerages–fueled in part by Blum’s newspaper and radio ads.

eager lawyers

With strong evidence of misjudgment by both brokers and investors, it would be unfair to simply lay the current bull market in legal claims at the feet of the lawyers. Still, they have played a part. Attorneys like Blum are eagerly looking for clients and juggling a crush of claims. Jacob Zamansky of New York City, who represented 46-year-old physician Debasis Kanjilal in his complaint against Merrill and Henry Blodget, says he has been “flooded with calls and e-mails” since news of the $400,000 settlement broke. And in Beverly Hills, attorney Aidikoff says he’s getting three times his usual volume of calls–and accepts only one in 12 investors. Explains investment industry executive recruiter Mark Elzweig: “The atmosphere has become so litigious that brokers who have been in the business for many years, and who have never had a compliance problem, are having clients bring or threaten to bring lawsuits. Some of it is just extortion.”

This environment was fueled by two recent landmark cases that may have created new incentives for lawyers–and their clients–to pursue brokers. In the first case, 77-year-old multimillionaire Henryk de Kwiatkowski, who lives a rarefied life in the Bahamas trading currencies and breeding horses, was awarded $164 million late last year by a federal court for market losses–believed to be the biggest solo-investor award ever. De Kwiatkowski had claimed that the negligence and bad advice of his longtime brokerage, Bear Stearns, was to blame for $300 million in losses on $6.5 billion worth of currency contracts. His broker called “every day,” de Kwiatkowski testified, and so when the dollar went against him, “I said, things are not going the way you predicted, and now I would like you to get me out today on the dime [like] you promised.” The case, now on appeal, was big news in the legal community, not only because of the size of the award, but also because de Kwiatkowski is the epitome of a worldly investor–and yet was successful in blaming his adviser. “If someone who does extreme speculation is not responsible, then who is responsible?” asks Walter Olson, a senior fellow at the Manhattan Institute and editor of Overlawyered.com.

In the second case, Marcia Roubik, a 51-year-old Illinois real estate broker, received a jackpot arbitration award against Merrill Lynch. Roubik had filed a claim over a $56,000 loss after the crash of 1987. Her case went all the way to the U.S. Supreme Court over technical questions on arbitration payouts. But Roubik stuck with it, and this past April she got her prize: a $2 million award, most of it punitive damages. While a Merrill spokesman argues that the award “wasn’t warranted,” the fact that Roubik’s payoff is 36 times her investment loss–far better than the S&P 500’s total return over the decade since her claim was filed–piqued plenty of interest in the securities bar.

Just about every plaintiffs attorney we interviewed reports an increase in the number of claims against large brokerages. No surprise there; that’s where the big bucks are. Most investors lawyers work on contingency–fees typically range from 30% to 45% of the payout–so the bigger the case, the harder they’ll fight. (“I won’t touch a case where the losses are less than $100,000,” says Blum.) “For the big brokerages, that’s the cost of doing business,” says Evan Rosenberg, a senior vice president in the financial services division of insurer Chubb.

On the class-action side, Wall Street’s increasingly publicized conflicts of interest are providing additional fodder. “The issue is an analyst putting a recommendation on a stock, and then the whole firm getting behind it to sell it,” says financial services consultant Donald Pitti. “It is the whole body of advice. That’s where the meat is, and that’s where the lawyers will go.” Indeed, Pitti suggests that the next move by class-action lawyers might be to put together a case for a company’s employees against their retirement plan’s investment adviser.

only the beginning

Perhaps it was predictable that a market downturn would bring out rising claims against brokers–it was this way at the end of past bull runs too. With so many people affected this time around, so many dollars lost and American society so litigious, maybe it’s no shocker to learn that legal activity is at record levels. Certainly investors who’ve absorbed big losses may feel they have little to lose, as lawyers scramble to take cases at no up-front cost. “It is almost like a free lottery ticket,” says Henry Hu, a professor of securities law at the University of Texas at Austin. “And lots of people pay good money for lottery tickets.”

But before you begin to think about litigation or arbitration as a turbo-boost for your depleted accounts, keep in mind that filing claims and suits is far different from winning them–especially when the issue of responsibility is so difficult to resolve. For all the notoriety of successes like de Kwiatkowski’s and Roubik’s, the broader picture is far bleaker. Class-action suits, as the dismissal of the Meeker suits demonstrates, face a difficult road in getting to trial, let alone in winning outright, and even successful bids usually leave the typical investor with minuscule awards, compared with the the lawyers’ take. As for arbitrations, historically only 46% of investors whose claims reach a hearing ever get payback, receiving just 36[cents] on the dollar for their losses, according to data compiled for MONEY by Securities Arbitration Commentator on claims against the top 10 brokerages over the past five years. It typically takes 14 months for an arbitration claim above $25,000 to work its way through the system–a process that can frustrate even the most patient person. Plus, since the most egregious behavior is often associated with smaller brokerages that then close down, only a third of plaintiffs who win in arbitration ever get paid in full, according to a General Accounting Office study.

Still, the rush of claims shows no sign of easing. Most everyone we spoke with, on both sides, agrees that as the bad news from the market meltdown sinks in for more and more investors–and as investors respond to the seeming success of high-profile cases like the one involving Merrill and Blodget–the number of new claims will continue to shoot upward. As David Harrison, a Los Angeles attorney who represents investors, predicts, “It’s going to be chaos.”


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