Actions Against Brokers Soar in Wake of Crash

Jesse K. Odell knew he would lose money if the stock market collapsed. But he didn’t know he could lose his entire retirement nest egg.

The 57-year-old retired Air Force officer sold his house and fast-food business earlier this year and invested the proceeds in stocks and stock options, figuring it would help him enjoy a comfortable retirement. He claims his broker never told him that the stock options he invested in put him at risk of losing his life savings.

Unfortunately, that’s exactly what happened. The Oct. 19 stock market crash wiped out his entire retirement savings of more than $300,000. The distraught Odell, who moved from El Paso, Tex., to Bradenton, Fla., may seek to recover his losses in arbitration on grounds that his broker failed to inform him fully of the risks.

“Never should a 57-year-old retired person have his whole fortune under that kind of risk,” Odell said. “Nobody in his right mind should do it, and no broker should allow it.”

Odell’s case is among the most extreme and troubling examples of a burgeoning number of investor complaints about their brokers stemming from the stock collapse--complaints that raise questions about the inherent conflicts of interest at brokerages while also illustrating the age-old tendency of consumers to invest in securities that they don’t understand.

These complaints and other problems arising from the crash will lead to years of bitter litigation and arbitration proceedings and have already prompted tighter rules at brokerage firms and closer scrutiny by regulators.

“The avalanche is yet to come,” said Irving M. Einhorn, regional administrator in Los Angeles for the Securities and Exchange Commission, noting the mounds of suits and countersuits that already have been filed. “We’re going to be living with (the litigation) for the next few years.”

Didn’t Inform Customers

The most serious, and troubling, of the complaints involve claims by investors that their brokers put them into extremely risky investments--such as stock options and margin accounts, in which investors borrow to finance investments--that were unsuitable for those clients, given their income, assets, age, job status and lack of sophistication.

In many of those cases, brokers did not adequately inform customers about the risks of the investments, the investors say. In some cases, brokers may have traded customer accounts without permission, altered customer account information or used other fraudulent means to get customers into those investments, which paid brokers lucrative commissions and other fees, the complaints say.

Some of those investments went up in smoke in the crash, in some cases leaving elderly retirees and others not only without their life savings but with thousands of dollars of debts owed to their brokerages as well.

A well-known West Coast entrepreneur claims to have lost more than $2 million and still owes at least $1 million to his broker. A 62-year-old New York widow, who earns only $12,000 a year and has an eighth-grade education, claims to have lost $600,000 in inheritance money and owes her brokerage another $400,000, which she doesn’t have. A retired 64-year-old Orange County woman claims to have lost her savings of $200,000 and now must go back to work.

“Many of these people weren’t aware of what was going on in their accounts,” said Michael Bertz, a Los Angeles attorney who handles investor cases against brokers. “Black Monday shook them out of their malaise.”

Brokerages also suffered as multimillion-dollar customer losses in such risky accounts helped prompt a large discount brokerage to curb its expansion plans, while a San Diego brokerage was forced to sell itself.

Costly Delays

Other types of broker-client disputes have arisen from the crash rubble. Some investors, for example, claim that they lost thousands of dollars because they could not reach their brokers or mutual funds by telephone on the week of Black Monday. Others complain that their brokers refused to see them in person or would not execute the trades they requested.

Still others complain that their brokers took as long as a week before executing their orders--delays that cost them thousands of dollars. Still others, who had borrowed in margin accounts to finance stock purchases, claim that their brokers liquidated their accounts in order to cover those loans, without giving them adequate notice.

One Los Angeles-area businessman claims he lost $2.5 million, and owes his brokerage an additional $1.2 million, in part because he couldn’t get trades executed on time to avoid the worst part of the Black Monday debacle. “He never considered that kind of risk” of not being able to trade, said Skip Raring, a Newport Beach attorney representing the businessman.

“The question of the protection of small investors on Black Monday and during the week of Oct. 19 is one that we are concerned with,” Securities and Exchange Commission Chairman David S. Ruder said. The SEC plans to determine whether brokers deliberately “put the small investor at the back of the line” in favor of larger clients, Ruder said.

Brokerages should “pay as much attention to the supervision of customer sales practices as they do to profits,” Ruder recently told the House Banking Committee.

But many regulators and legal experts say that a good number of investors who couldn’t reach their brokers, suffered trading delays or saw their margin accounts liquidated without notice may have a tough time getting redress through the courts or arbitration.

Under a legal standard of “reasonableness” used in such cases, brokers probably cannot be judged as unreasonable simply because they didn’t have enough phone lines to handle the historic trading volume on Black Monday, when more than 600 million shares changed hands on the New York Stock Exchange, about double the previous one-day volume record.

Investors in these cases would have to prove that the broker was not reachable because of negligence or other intentional behavior, legal experts say.

“If 20 phone lines are reasonable for a brokerage to have on a normal business day, you shouldn’t expect them to have 100 phone lines just for the busiest trading day in history,” says G. William McDonald, enforcement chief for the California Department of Corporations, which regulates securities firms in the state.

Brokers also have emergency clauses in their margin account agreements with customers that allow them to exert wide discretion in liquidating customer accounts without giving notice.

On the other hand, these experts say, investors unwittingly put into unsuitable investments are in a much stronger position to get redress. These suitability cases, as old as the brokerage industry itself, point out the inherent conflicts of interest in a system where brokers

are rewarded for selling investment products while also being required to protect customers from the most imprudent of those investments.

If investors are told of the true risks in some of these investments, they wouldn’t invest in them, said Robert Dyer, an Orlando, Fla., attorney who represents a number of aggrieved investors.

“If it (the full risk) had been brought to my attention, I doubt very much I would have participated to the extent I did,” said Frank W. Boyle, an 81-year-old retired businessman from Ormond Beach, Fla., who claims he lost more than $400,000 in the crash, largely from risky options trades.

To be sure, investor complaints about their brokers had been growing even before the crash. Complaints against brokers registered with the SEC had more than doubled between 1982 and 1986. The complaints often involved unsuitable investments, misrepresentation of investments, “churning” (in which a broker generates abnormally frequent trades solely to earn higher commissions), unauthorized trading or such fraudulent activities as forging of customer account statements.

Euphoria Ends Abruptly

Many of the complaints, however, simply have been an expression of sour grapes by investors who lost money but tried to pass blame on to their brokers.

Such complaints in many ways were an inevitable result of the bull market and the recent proliferation of new, exotic--and risky--investment products.

Drawn into the euphoria of the 1982-87 bull market, in which the Dow Jones industrial average more than tripled, the number of investors more than doubled between 1980 and 1987--to 47 million, or one in every five Americans. Many of these new investors did not understand the new and complex investment products, such as futures and options on stock market indexes, that proliferated in this period.

“Any time you have exotic investments and a low level of investor sophistication, that’s an extremely dangerous combination,” said Scott Stapf, spokesman for the North American Securities Administrators Assn., a group of state securities regulators that set up a telephone hot line after the crash to handle investor complaints. Calls to the hot line have totaled as many as 500 to 600 a day, five times above expectations, Stapf said.

But for many brokers--whose numbers also ballooned with the bull market--the exotic products were a potential gold mine. They paid far higher commissions and fees than selling traditional stocks, bonds and mutual funds, says Edward B. Horwitz, a broker and compliance consultant at the Los Angeles-based brokerage of Bateman Eichler, Hill Richards.

Brokers, Horwitz says, typically earn commissions of 1% to 2% on stocks and 4% to 8% on mutual funds. But options--which give investors the right to sell or buy a particular stock or stock index at a certain price within a specified period--generate commissions of as high as 15%, Horwitz said.

And because options usually require frequent trading, a broker in effect can earn much more. In some highly traded accounts, as much as 40% of the cash value of the account goes into commissions, Horwitz says.

Among the most attractive--and potentially dangerous--of the new products have been options on such stock indexes as the Standard & Poor’s 100, often called the OEX option. Some brokers had their clients selling “naked, out-of-the-money” put options on that index, convincing them that such options would provide steady income with little risk.

‘Naked’ Puts

Those options obligated those investors to buy contracts on that index at a set price. By being “out of the money,” that price was set far below the current level of that index, so that it would be unprofitable for the holder of the option to exercise it unless the market tumbled precipitously. They were “naked” because they were unhedged--not backed by holdings of the underlying stocks or of offsetting options that would limit losses in case the market plunged.

As long as the market stayed relatively flat or rose, the sellers of such options earned a steady income from the premiums on the options. And because the market largely went up between 1982 and 1987, many investors earned tidy profits from selling naked puts and were lured by their brokers to think that such investments were largely risk-free.

“It was like an annuity--when the market always went up, those options never came into the money,” the SEC’s Einhorn said. Brokers kept writing these options for clients “because it was easy money.”

But when the market collapsed, such options came “into the money,” meaning that sellers had to buy index contracts at the far higher, pre-collapse prices. That resulted in gigantic losses for the sellers of the naked puts (and correspondingly big profits for the buyers).

And because such options were sold on margin--meaning that investors put down in cash as little as 10% of the options’ value, borrowing the rest--their losses ran as much as 10 times what they had invested.

Dennis Coffey, a 50-year-old food-industry executive from Burlingame, Calif., claims that his broker told him he could lose no more than $10,000 from selling naked put options on the Standard & Poor’s 500-stock index.

But in fact, he lost the entire $40,000 that he had in his brokerage account and owes another $40,000 that he says he doesn’t have.

“It was a foreign language to me,” Coffey said of his lack of understanding of options, noting that his broker did all the trading. “I just trusted this guy; I never questioned it.”

Coffey now contends that his broker--who had been in the business only a year--also did not understand the risks and was not sophisticated enough to be trading options.

“I really believe the broker got in over his head. He had no idea of the downside risk,” Coffey said, adding that his brokerage has acknowledged some responsibility and agreed to settle his case by forgoing some of the debt he owes them.

Some customers contend their brokers put them into options without their permission or authorization. A 48-year-old Los Angeles businesswoman claims that her broker engaged in a series of unauthorized options trades, in which she lost $10,000, even though she had never signed an agreement authorizing options trading or given her broker discretionary control over her account.

Margin Accounts Risky

Still others claim that their brokers falsified their account statements in order to justify putting them into options. Some firms, for example, won’t allow unemployed customers to trade options. But a 45-year-old computer consultant from Orange, who asked not to be identified, claims that his broker put on his account statement that he was employed--even though he was unemployed at the time he opened the account. He claims that he lost his entire $425,000 in savings, $305,000 of that from trading naked put options. He claims his broker told him he was risking only $25,000 in the investments.

The problems, although more serious in options, also involve investors in margin accounts. Experts contend that most investors, particularly elderly people investing their life savings, really have no business buying stocks on margin. (In a margin account for stocks, an investor is allowed to borrow up to 50% of the value of the stocks. Such leverage can double the investor’s potential profit but also doubles the potential loss, so that an investor could lose twice his investment.)

Margin calls, in which investors are asked to put up more cash or stock to replenish the declining value of the collateral backing the margin loan, were a major cause of investor disputes.

Some investors claim that their brokerages didn’t follow their own rules concerning margin calls. Brokers are required under federal regulations to issue margin calls when the equity in an investor’s account falls to 25% of the value of the investment.

Frank W. Boyle, the retired businessman from Ormond Beach, Fla., claims that his broker should have issued a margin call or closed out his account in September, when he claims the equity in his account fell nearly to 10%. Instead, his broker told him to hang on because the market would go back up and he could recoup his losses.

Paying the Price

“They were hoping things would change,” Boyle said. “They didn’t want to close out my account because it generated very good commissions.”

Instead, the market collapsed a month later and Boyle lost his $400,000 in life savings and now owes his broker at least another $160,000. “If they closed out my account when they should have, my losses would’ve been cut in half,” he claims.

Brokerage firms also are paying the price for instances where customers cannot pay the money they owe from massive losses in options trading.

Charles Schwab & Co., the nation’s largest discount brokerage, reported a $22-million loss in October, $15 million of it due to losses of a single client.

San Diego Securities, a small brokerage firm, was forced to sell its assets to a Los Angeles-based firm following losses from several customers lured into options trading by a single broker in its La Mesa office. The broker, Chik Hylton, had described the options as “safe and prudent,” according to lawsuits filed by the disgruntled investors.

Under consumer protection rules promulgated by stock exchanges and self-regulatory organizations, brokers are responsible for fully disclosing the risks of any investments they recommend. They also must be responsible for knowing their client’s financial and employment conditions, degree of sophistication and investment objectives, and recommend only those investments suited to the client.

Abuses ‘Rare’

If a client insists on an investment that the broker knows is unsuitable, the broker should try to dissuade him from such a move, says Stapf of the North American Securities Administrators Assn.

But brokerage industry officials, while acknowledging some abuses in options, claim that they were rare and that the vast majority of clients were treated fairly in the crash. Many complaints, they say, are simply from investors trying to blame brokers for their losses.

Investors rarely complained about the profits they made from options strategies in the five years of the bull market, industry officials contend. These investors in most cases were told of the risks but forgot such conversations or did not pay attention, the officials say.

“It’s not a broad problem,” said Hardwick Simmons, a vice chairman of Shearson Lehman Bros. and head of its retail brokerage operations. “For those individuals (that were hurt), they were very serious, but those problems were few and far between.”

Nonetheless, since the crash, Shearson and many other brokerages have tightened their rules governing who should be allowed to trade options and are instigating tighter supervision of brokers with clients in options.

Shearson, for example, has fired at least one broker for options trading abuses since the crash, Simmons said. The firm also now requires that anyone trading “out of the money” options must have a minimum of $100,000 in an account to start, a rule that Simmons contends will increase the chances that the investor is sophisticated enough to understand options trading. Previously, there was no minimum-account requirement.

“The chastising that took place as a result of the Oct. 19 debacle has made everybody aware of the dangers,” Simmons said. “I doubt we will go through any replay (of the problems stemming from the crash), even if there is another similar cataclysm.”

Requirements Tightened

Also, several firms have tightened margin requirements on options trading, in some cases requiring that investors put up at least 25% of their own money to trade, up from as low as 5% to 10% before.

“It’s less of a gambling activity now,” the SEC’s Einhorn said. “You have to put up some serious money.”

Regulators and exchanges, such as the Chicago Board Options Exchange, where the S&P; 100 index is traded, also are studying tighter margin requirements and other new rules. Some congressmen and others are even calling for an outright ban on stock index options trading, a move vigorously opposed by the securities industry and by institutional investors such as pension funds, which use options to hedge their large holdings against losses.

Regulators and exchanges such as the SEC and the NYSE also have been increasing their enforcement and supervisory staff, although most of these increases have been targeted at curbing illegal insider trading rather than broker-client abuses.

However, the biggest reforms are likely to occur in the arbitration systems set up by the exchanges and the National Assn. of Securities Dealers to handle broker-client disputes involving member firms. Many investors, attorneys and regulators perceive these arbitration systems as unfairly stacked in favor of brokers, in part because panels are selected and administered by the securities industry. Also, critics say, many arbitrators who are supposed to be impartial in fact have direct or indirect ties to brokerages.

Investors contend that they are already disadvantaged enough. Few attorneys, they say, are willing and able to defend them, particularly in arbitration cases where panels rarely award punitive damages against brokerages, even in the most clear-cut cases of abuse.

Such concerns about arbitration have taken on added urgency because a flood of arbitration cases is expected to be filed due to the crash. Also, a Supreme Court ruling in June made arbitration a more likely avenue than civil lawsuits.

Some reforms already are in place. The NYSE, for example, is requiring greater disclosure of arbitrators’ backgrounds and is making it more clear to them that they can award punitive damages and attorneys’ fees, said Edward W. Morris, the Big Board’s arbitration chief.

Experts agree that such changes will be helpful, but they disagree about whether the problem of investor abuse will abate now that the bull market is over.

Some say brokers already are beginning to stress more conservative products, such as certificates of deposit and money-market mutual funds, to investors rattled by the stock debacle.

Others, however, say the problems will get worse, because such simple investments as CDs and money-market funds don’t earn much in commissions. Also, investors will always be susceptible to sales pitches for investments with claims of quick profits with little risk.

“You’re going to see more high-risk strategies sold as conservative investments,” Florida attorney Dyer said.