THE BLOG

Rich and Poor Serve Their Wall Street Masters

01/25/2011 07:57 pm ET | Updated May 25, 2011

I am often accused of being too hard on brokers (usually by brokers!). They say I cherry pick bad portfolios and there are many "hard working, honest brokers" who do the right thing for their clients.

That has some surface appeal and I used to believe it. I no longer do.

I have reviewed thousands of portfolios sent to me by readers of my books and blogs. I have yet to see a globally diversified portfolio in an appropriate asset allocation, invested solely in low cost, high quality, stock and bond index funds, exchange traded funds or passively managed funds. Not one!

I also regularly review findings (misnamed "awards") issued by the Financial Industry Regulatory Authority (FINRA) which has exclusive jurisdiction over disputes between investors and their brokers. In last week's blog, I wrote about the experience of Joanne Bohnke, a 74-year-old widow of modest means, who was harmed by the misconduct of her broker. She got partial recompense, which is rare for investors, since these panels tend to either side totally with the securities industry or award only a fraction of the damages suffered by the investor.

Wealthy investors fare even worse, both with their brokers and with FINRA arbitration panels. Lawyers for the broker brand the wealthy as "sophisticated investors", implying that their financial success in their business life made them fair game for the machinations of their broker. The panels usually buy this defense and rarely make any meaningful awards in these cases.

For this reason, my curiosity was piqued by an award (Case Number: 08-04276) in an arbitration brought by James D. Murphy, a 61-year-old Florida retiree, against Salomon Smith Barney. The panel awarded Mr. Murphy $1,042,986.22, plus interest. This is a big number for a FINRA award.

According to Robert Savage, Tampa based counsel for Mr. Murphy, his client had net losses in his portfolio of almost $2.3 million, representing a significant portion of his initial investment of $4 million. Mr. Murphy had been a conservative investor, with a portfolio consisting almost exclusively of municipal bonds, which he held to maturity. His broker persuaded him to use these bonds as collateral, and buy stocks on margin with the proceeds.

According to the Statement of Claim, the activity in Mr. Murphy's account was stunning. He started with an average equity in his account of $3.6 million in 2003 and ended with an average equity of $1.3 million in 2008. During this time period, his broker turned over his account thirty times, racked up a whopping $807,301 in margin interest and (according to Mr. Savage) $500,000 in commissions.

When I talk about the transfer of wealth from you to your broker, this is precisely what I have in mind. On an account with an average equity of $3.6 million, the brokerage firm gained $1.3 million (in commissions and margin interest) for "managing" this portfolio. Mr. Murphy's average equity decreased from $3.6 million to $1.3 million during this period.

Viewed in context, the award of the FINRA tribunal fits into a familiar pattern. The panel simply required the brokerage firm to return most of the gains it made from its wrongful conduct. It should have awarded what are known as "well managed account damages", which is the difference in the account as managed and what it would have been if the account had been invested in a globally diversified portfolio of low cost stock and bond index funds, in an appropriate asset allocation for Mr. Murphy (or it could have used other appropriate benchmark investments).

There are no circumstances which would justify the excessive trading and margin interest in this account. It would be unsuitable for any investor, except a day trader.

I ran some numbers which are interesting. I assumed the right asset allocation for Mr. Murphy was 60% stocks and 40% bonds, which gives the broker the benefit of the doubt since it is probably too aggressive for someone Mr. Murphy's age. I used an initial investment of $3.6 million in 2003 and computed the value of the portfolio on December 31, 2008, using a passively managed portfolio of stock and bond funds. The ending value was $5,051,660! The panel should have done a similar calculation and made an award that would have compensated Mr. Murphy for his real losses.

In addition, since there is no justification for this amount of margin (or any margin) or for the excessive trading in this account, the panel should have assessed punitive damages, attorneys' fees and all costs against Salomon Smith Barney.

Instead, it denied Murphy's request for attorneys' fees and for punitive damages. In a final blow, the panel assessed Mr. Murphy $15,300 in hearing fees. It assessed the same amount against Salomon Smith Barney.

Mr. Savage stated there was no settlement offer in this case. I am not surprised. There is no incentive to settle when you are confident you will either prevail at the hearing or, at worst, have to give up just a portion of your ill-gotten gains.

Whether you are rich or poor, you need to understand the present system is set up to transfer your money from your pocket to the coffers of your brokerage firm. They have closed the loop with the cozy FINRA mandatory arbitration scheme. No matter how bad the conduct of your broker, if you recover at all, it will likely be for a small portion of your losses, which will be further reduced by attorneys' fees.

A corporate representative for the brokerage firm would not respond to questions concerning the case. His comment was limited to noting "respectful disagreement" with the award.

He should have been thrilled with it.

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