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Ten Commandments Can Save Brokers a Fortune by Eliminating Arbitrations Before They Occur

The information contained in this article is intended for informational purposes only and should not be construed as legal advice or a substitution for obtaining legal advice from an attorney licensed in your state. Reading this article is not intended to create an attorney-client relationship. For personal legal advice, please consult an attorney of your choice. Because of the possible unanticipated changes in industry regulations and applicable state and federal laws, the authors and creators and any and all persons or entities involved in any way in the preparation of this article disclaim all responsibility for the legal effects or consequences of the interpretation of the information provided.

It’s 3:45 p.m. on any particular 15th of the month, the end of the pay period. You have $27,500 gross in and need an additional $2,500 in commission to hit your breakpoint. It means the difference between a 35% payout and a 50% payout for the month, basically, another $5000 or so in your pocket.

You’ve just received notice of a $3,000 special assessment for your condo, your wife is looking forward to that vacation in Barbados you keep promising her and MasterCard actually has hit men looking for you. The 22-year-old kid you trained is now bucking for your office and if one more prospect tells you they are only investing in real estate until the economy turns around you are going to need a prescription for Prozac. Last but not least, one of your precious new accounts reneged on a trade last month and you’re in the hole to your firm to the tune of $5,400 for a two point drop in a technology stock that you were dead sure was going to revive your book. Now you’ve gone from “dead sure” to just “dead.”

Until the $5,400 “hit” you were making tremendous strides redirecting your business since the bubble burst in the cold spring of 2000. You started doing more mutual fund business and gold funds kept you out of the poor house while a lot of your old buddies fell by the wayside. But now it’s go time; time to flex as a true professional and show your sales manager you’re the consistent producer you keep telling people you are.

Just one innocent little ticket for $100,000 into a value-based mutual fund will do the trick. After all, how can buying quality hurt anyone? There’s a 3.5% load on the fund so you hit your breakpoint, the client is further diversified and the hit men from MasterCard give you a pass for one more month.

Problem being is that you’ve already called the last of your “go to” guys and you’ve been unable to make voice contact with the one you really need to speak with. He’s on the golf course and has left specific instructions with his secretary not be disturbed. He did however, tell you to go ahead if anything ever looks good and you can’t reach him. Then again, the guy who busted the trade on the technology stock last month said the same thing.

It’s now 3:50 p.m. and the window of opportunity is about to be slammed on your fingers. You open your book, grab a trade ticket and…

Even brokers with the best of intentions and highest regard for their clients well being find themselves in this predicament. But moves like this can be costly. And in some cases brokers have even lost their licenses for doing what they’ve seen other brokers do hundreds of times, running a “UT” or unauthorized trade. In summary, there’s no sense throwing away a dollar to make a dime.

There are Ten Commandments to avoiding lawsuits when working a book as a retail broker. These rules are not absolute, but implementing even a few of them will help insulate yourself and your firm from liability that can easily be avoided.

It is never, under any circumstances, permissible to run trades without specific authorization to do so from the client. Although ever broker knows this fact several common scenarios do occur that have a tendency to blur a registered rep’s fundamental common sense. In the case where your client is married but has opened a single account, do not accept authorizations from the spouse who is not on the account, even if they are easier to contact during trading hours. If it is an elderly client, it is still not acceptable to accept trades from the son or daughter who understands your recommendations more easily. Either way, the account is being directed by another party who does not have legal authority to do so. In the event losses are incurred you will face an arbitration panel and there will be no defense, or even a logical explanation, as to why the account was being traded by an unauthorized party.

The easiest way to neutralize these two common liability scenarios is to either have the client sign a limited power of attorney to the son, daughter or spouse, or simply have them complete the necessary paperwork to make the account a joint trading account. Either way, invest a little time up front as opposed to investing an inordinate amount of time later preparing your defense in arbitration, or even worse, an action from a regulatory body.

If the client is the type of guy you’ve been trading a while and has instructed you to act on his behalf if he can’t be reached, then by all means make him put his signature where his mouth is. Get a limited trading authority document through your compliance department and have the client execute it. In the event the client won’t sign it it simply means they were setting you up for a fall anyway in the event that losses were incurred by your actions.

At the risk of sounding paranoid, treat every client like a potential lawsuit. Since most arbitrations occur approximately 12 months after the account is closed by the client, do not rely on the fact that your memory will provide you with the necessary facts to assemble a viable defense.

Most firms require that brokers keep thorough work notes throughout the duration of an account. Whether your firm does or does not, it is essential that you maintain a complete daily log of every transaction you execute. These log entries do not have to be exceptionally long but they do have to include enough detail to substantiate what you were buying for the client, when they authorized the trade and ideally what they were doing or where they were when they gave their authorization. Documenting this last element of your conversation with the client will prove beyond a shadow of a doubt that you did not go back and recreate your notes after the fact.

Remember, if a client files a complaint twelve months after the fact you are looking at another eight to twelve months of discovery and trial preparation before you and your counsel get to tell your side of the story to an arbitration panel (assuming the case is not settled out in the interim). This means that two or three years may elapse from the time you lose the client to the time you have to defend your credibility and your license. Details can become sketchy in weeks, no less months or years.

Although there are typically three to five causes of action in client arbitrations, careful notes can provide a sure-fire defense against allegations of unauthorized trading. As the old sales adage goes, your notes can truly be you life.

This is a prime example that alliterates the fact that ignoring a problem is not going to make it disappear. Most brokers separate their business into an “A” book and a “B” book. Larger producers even have a “C” book.

Superstar producers build their careers on clients, not accounts. Pre-screening is the cornerstone in building a successful business because even under ideal circumstances the pressure of successfully trading a retail portfolio can be nerve-racking. Add a handful of livid clients or professional complainers to the mix and you have a recipe for disaster. In this instance it is no longer a matter of if a client will sue; it becomes a matter of when.

It is imperative to search out the weeds in your garden before they grow so large that they create a stranglehold on you entire business. Typically these land mines are buried somewhere deep in your B or C book; the clients you have the thinnest relationships with. But you know who these people are already. Problem being is that you refuse to admit it because they make your equity run look just a bit fatter. It is the rare breed of broker who possesses the nerve to turn down business. It is also this same rare breed that generates few or even no complaints from clients throughout the course of their career.

Remember, the most natural reaction from brokers when they realize they are saddled with a problem client is to hand them off to a less experienced broker who needs the business and is willing to put up with the headaches. After all, getting 50% of something is better than 100% of nothing, right? Wrong!

This approach is fundamentally incorrect on two levels. You are transferring a problem account to another, usually less experienced broker, who possesses even weaker public relations skills than you do, exacerbating an already volatile situation. Secondly, out of sight out of mind does not work in this situation because in the event the client files a complaint his or her attorney will name ALL parties involved. This includes everyone from the principles of the firm, the attending sales manager or “24”, the clearing firm in some cases, the broker who opened the account and any other broker who traded the account during its duration.

If you feel a client is a potential problem it is imperative that any active trading be ceased. Encourage the client to assume a cash position and odds are they will eventually withdraw their account.

If a client is resistant to “go to cash” then forward prospectuses on several high-grade mutual funds to them and of course document this in your notes. All decisions should be made strictly by them. In the event they decide to reposition into a select basket of mutual funds they must clearly understand that this is a five-year strategy. If they are not willing to respect the time frame of this approach you should once again advise them to purchase a CD or government bond, regardless of the payout.

Brokers with the widest variety of business seem to generate the lowest percentage of client complaints. Let’s face it, brokers who focus strictly on trading aggressive growth equities bear the brunt of the fallout when the markets correct. They make the most when markets are rallying but inversely suffer the most dramatic swings in equity when the economy gets choppy. But expecting a top-producing stock jock to turn into a financial planner or annuity salesman overnight is more like turning coal into a diamond. It’s going to happen but it’s going to take time and there are going to be flaws.

Over the past ten years the tide has turned against brokers who handle aggressive trading clients. Even in an ideal market losses are incurred and losses invariably equate to complaints, and you’d better be sure that one of the primary causes of action in that complaint will be churning.

Securing a variable life, health and annuity license is a great way to bolster your business while managing the inherent risks of trading equities for your clients.

Forcing a round peg into a square hole is generally not recommended in any business capacity, especially in the securities industry. So an insurance license will allow you to handle lump investment sums from your clients confidently while still keeping up your production level. Variable annuities provide maximum diversification, and although they can decline in value, they are still on the opposite side of the risk spectrum from trading separate equities.

If you intend to follow the Fourth Commandment the way it is intended, then spread yourself out into bond business as well. It is shocking to see how many brokers make it through their entire career without ever buying a single bond for their clients. Bonds can provide growth as well as income and from a risk perspective they run the gamut from conservative to very aggressive. If you really want to set yourself apart from the pack then take a few weeks and secure a Bond Principle license. Once again, this will provide you with an even stronger knowledge base of the bond business while reinforcing your credibility as a financial professional.

If you desire to create hedge positions for your clients in turbulent times then take the necessary courses to understand what a Registered Options Principle (ROP) really does. While trading options outright maintains the highest end of the risk spectrum, buying options the way they are intended to be used, as part of a hedge strategy, can provide stability and income to your clients.

In summary, if 25% of your income is derived from trading equities, 25% from buying and selling bonds, 25% from insurance business and the remaining 25% from creating options positions then in all probability your chances of generating a formal client complaint should drop dramatically.

The brokers who generates the most complaints is the usually the one with the smallest client base. Brokers with the least clients generally overtrade and percentage wise, the numbers never work out.

The last position you want to be in is trying to explain why a $125,000 account generated $115,000 in gross commissions over the course of two years. Although this situation is quite easy to create it is also quite easy to correct.

In addition to client complaints, actions from regulatory bodies have grown increasingly commonplace when it comes to the overtrading of client accounts. One factor that is viewed by the powers that be is not just how much commission a brokers generates but when he does so. If a government agency or SRO views your company’s commission runs and discovers that 50% or more of your total commission is generated on the last three days of your company’s pay period then it will appear that you were executing trades solely for your own benefit, typically to hit a production breakpoint.

Also, if it is deduced that all of your accounts possess a high ratio of equity to commissions then it will show that your business as a whole is improper. The sanctions for conducting such business can be steep fines ($5,000.00 or more), suspensions, or worst possible scenarios, revocation of your series 7 registration.

To correct this, set a routine and stick to it. Your machine for prospecting new business should run smoothly and consistently. If you are just starting out then be sure to dedicate at least 75% of your working time towards building your client base and if you are a more established broker than you should assemble a team of support staff dedicated to helping you build your book. The most successful producers are the ones who have mastered the art of “divisional” sales so that their time is freed up to service their existing client base.

A larger, more diverse client base will eliminate the temptation to overtrade a handful of clients who, although they are more than willing to follow your lead, will definitely file a complaint in the event excessive losses are incurred. Every client is your best friend until they lose money.

Secondly, gross production must be generated and measured on a daily or weekly, not monthly, basis by the broker seeking to maintain superstar status while preempting potential client complaints and regulatory actions. Under no circumstances is it permissible to generate the bulk of your monthly production on the last two or three days of the production period unless there is a legitimate reason to do so (i.e. a large transfer has just hit up or possibly certain equity positions have blossomed to their potential and must be liquidated).

Brokers who are conscientious about avoiding arbitrations must not just eliminate business impropriety; they must eliminate even the appearance of impropriety.

Produce new accounts and gross commissions consistently and your business will run smoother from a production as well as legal standpoint.

The drug company you’ve just built a substantial position in has stalled out in second stage clinical trials for their revolutionary new cancer drug and the news has been less than flattering to the share price of their stock. As a matter of fact, CNBC has just started using words like “debacle” and “meltdown” and your clients want answers – NOW.

Your message caddy is bursting and your secretary is now asking for combat pay. The last thing you should do right now is crawl for the womb-like safety of the space beneath your desk.

Most clients understand the fact that risk and reward are commensurate in an active trading scenario. They equally understand that they are putting big commission dollars in your pockets and for paying this price they want service.

Nothing replaces the power of sincerity. If your client calls and you are genuinely time pressed and cannot speak with them or do not posses the answers that they are looking for then tell them so. Take their call quickly and explain to them that you are researching the situation and set a time to call them back. Most importantly, if you set a time stick to it.

Resist the urge to let the call roll through to your voice mail and do not relay messages through your secretary or sales assistant. If your clients had little or no difficulty reaching you when times were good then they should be able to reach you with the same degree of ease when markets are heading south. In times of crises communication is more important then ever.

You can eliminate a large percentage of client complaints just by showing your clients you are a professional at all times.

Although tempting as it may be, it is highly unadvisable to buy anything you can’t pay for outright. After all, if buying stock on margin was such a good idea you’d be doing it for your own account, right?

In a declining market cutting losses can be an art form in itself. Attempting to salvage equity from a leveraged stock position is typically futile. Not to mention, margin costs can be substantial and also eat into client equity day in and day out. It’s like buying a million dollar mansion without thinking about how you are going to make the mortgage payments, discovering the house is on a fault line and then being informed it has termites. You’re either going to lose fast or lose slow. Either way, you’ll lose.

Clients can accept reasonable losses if you’ve made all trades with the best of intentions and done your best to cut losses and let profits run. They will not, however, accept the fact that they’ve lost 75% of their equity after you promised them a home run and told them that margin was only going to be used temporarily. Well, the losses have a way of becoming permanent and although you may have used margin temporarily the effects are lasting. A client arbitration is all but guaranteed.

If you want to double the size of your book than hit the phone and raise equity. When in doubt the basic rule of thumb is don’t do anything with client equity you wouldn’t do with your Mom or Dad’s.

Leverage your client out of the market and their attorney will crucify you and your supervisors for breach of fiduciary responsibility. Once again, eliminate this practice from your business.

Another common cause of action from a client in the average arbitration is the allegation that they did not understand, or were not informed, of the inherent risks involved in trading separate equities, particularly NASDAQ issues. Granted, the average disclosure document that is produced by the clearing firm is enough to scare anyone out of the water forever, but statistically, these documents are not read.

If indeed they are read and executed by the client they still have the right to claim that they did not understand what they were signing and that you, the attending broker, minimized or did not emphasize the risk involved. Sure, anyone can claim anything, but why give the client more ammo than they already have when filing an arbitration?

The average broker can paint a rosy picture around anything, but when reality doesn’t sync up with the idealistic scenario, the client feels like the carpetbaggers have come to town. No one likes being made to feel stupid or misled.

Clients respect and appreciate a broker who tells it like it is. People who have the money to invest are generally pretty astute. That’s how they got money to begin with. They understand that there are no free lunches and if you want to get anywhere in life you’ve got to take on risk. But risk is best conquered with eyes wide open.

Tout the risk whenever possible and refer back to the 2nd Commandment, taking careful notes of these conversations.

Picture this if you will. An elderly woman draped in a hand-woven shawl takes the stand at your first arbitration. She is in her late 80’s, has a thick bun of gray hair tucked beneath a conservative flowered hat and moves slowly and deliberately as she prepares to tell the panel how she lost nearly $300,000 trading $5 and $10 NASDAQ technology stocks.

After her attorney gets through questioning her it becomes completely apparent to all in attendance that her only previous investment experience consisted of a portfolio of bonds and dividend-producing utility stocks. She explains that after her husband died it was up to her to start making her own financial decisions and that you, the broker, lured her to her financial demise with promises of higher returns.

Regardless of the fact that she actually was referred to you by an existing client, and that she hounded you incessantly to pursue double and triple-digit returns (the kind she kept hearing about on CNBC), you have now brought a knife to a gunfight. Regardless of how thorough your defense is you are going to wind up spending the rest of your career paying off a hit so large that just thinking about it causes you to spiral into a panic attack.

The best defense in this particular scenario is to not have been there to begin with. Even though the client has met all the traditional net worth requirements and was as sharp as Louis Navalier when reviewing account statements, prospectuses, analyst reports and the like, don’t think for a minute they won’t play the age card to take a shot at getting their money back if things don’t work out.

If you decide to pursue a business relationship with a client who is over the traditional age or possibly has limited trading experience but seems to be dead set on becoming an active trader, it may be advisable to create an audio taped disclosure that can be admitted into evidence later. Obviously, coordinate the details of this procedure with your compliance department in order to adhere to all pertinent rules and regulations.

In addition to certain standard language that should always be included, let your clients know that they have three different options to choose from when entering the market: conservative, moderate or aggressive. Conservative means that their primary goal is preservation of equity. Moderate means that they are willing to accept losses when pursuing above-average gains. Aggressive means that they are willing to accept a complete loss of their investment dollars. Instruct the client to tell you which category they fall into before you begin trading the account. Best possible scenario is that they explain their personal risk tolerance in their own words as well. Of course, refer to the 2nd Commandment and document this conversation thoroughly in your notes in addition to the audiotape you’ve just created.

If the first nine commandments sound time consuming consider the fact that practicing them can literally save you and your firm hundreds of thousands, if not millions, of dollars in reparations, fines and legal costs.

The last Commandment is going to cost you a few dollars up front, but is well worth the expense. Look at it in the same light as you would view spending money on a cancer screening or even on an MRI to diagnose a potential back problem. Remember, it is always cheaper to prevent a problem than to fix one.

If you handle a book in excess of ten million dollars that means that even a 20% drop in equity can start a chain reaction that can leave you owing your clients or your firm between two and four million dollars (actual losses coupled with missed reasonable profits and attorney’s costs).

Securities attorneys charge anywhere from $200 to $300 per hour and are adept at diagnosing potential liability. For the sake of argument assume that you will retain an attorney twice a year to review your business practices and advise you where to make adjustments pertaining to record keeping, suitability issues and the latest industry requirements. If your first reaction is that your compliance officer does that job already, keep in mind that it is the compliance officer’s responsibility to protect the firm, not you, in the event of any litigation.

So you have to make a serious decision; is spending $5,000 a year to have an industry professional fortify your business more desirable than potentially giving back several hundred thousand dollars should an arbitration not go your way? Savvy brokers typically have a long-term perspective on their business and would rather be safe than sorry. They realize that spending a small percentage of their hard-earned income to establish a relationship with a securities attorney is as essential as health insurance or liability coverage on the cars they drive.

In addition, having a strong, ongoing relationship with a securities attorney will also eliminate the last minute stress and aggravation of scrambling to retain counsel should a client or regulatory body name you in an action.

Laura Anthony is the founding partner of Legal & Compliance, LLC, a corporate and securities law firm specializing in securities & regulatory matters, business transactions, commercial litigation and entity formation. She is also a member the NASD Dispute Resolution Board of Arbitrators and can be reached at 800-341-2684; by e-mail at LauraAnthonyPA@aol.com or contacted through the company’s web sites http://www.LegalAndCompliance.com and http://www.MyWebLawyer.com.

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Laura Anthony, Founding Partner e-mail: lanthony@legalandcompliance.com	800-341-2684 fax: 561-514-0832
Legal & Compliance, LLC 330 Clematis Street, Ste. 217 West Palm Beach, FL 33401	Legal & Compliance, LLC 940 Lincoln Road, Ste. 319 Miami Beach, FL 33139

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