Monthly Archives: April 2014

The Puerto Rico Bond Crisis and Its Effect on U.S. Investors

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By Thais DelaCuba

The Puerto Rico Bond Crisis has had a large impact on the United States’ almost $4 trillion municipal-debt market, which includes bonds issued by states and other local authorities as well as by cities. As a result of the sinking market, Puerto Rico’s current debt is between $52 billion and $70 billion, which is the third largest in the United States, only behind California and New York.  This amount of debt is alarming because Puerto Rico has a much smaller and poorer population compared to other heavily indebted states. Indeed, according to the Economist, the average state debt to personal income ratio is 3.4% in the United States, whereas Moody’s rating agency puts Puerto Rico’s tax-supported debt at 89%.

The current financial instability of Puerto Rico may have a grave effect on many smalltime investors around the United States. This is because U.S. mutual funds are heavily invested in Puerto Rican bonds due to a special tax exemption, which allows Puerto Rican bonds to be triple tax-exempt. In short, this means that bondholders do not pay federal, state, and local taxes for their coupon interest from the bonds. According to Morningstar, as a result of this exemption, around 70% of U.S. mutual funds own Puerto Rico securities.

The special tax exemption – which was intended to bring investors and business onto the island – has ultimately created the financial crisis occurring in Puerto Rico today. The financial crisis began in 2006 when a federal tax break for corporate income expired, which prompted many businesses to leave. Subsequently, unemployment on the island increased drastically and Puerto Rico began borrow funds to avoid further deficit. Finally, in February 2014, all three major ratings agencies downgraded Puerto Rico’s debt to below investment grade, widely referred to as ”junk” status. This indicates a greater risk of possible default or a debt restructuring. For U.S. investors, this means that the crisis in Puerto Rico will have a severe impact – not only on Wall Street, but also on thousands of everyday investors.

The Lehman Brothers Saga Continues: Broker Wins $5.4 Million Against UBS

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By Abirami Ananthasingam

On September 15, 2008, Lehman Brothers filed the largest bankruptcy in history with over $639 million in assets and $619 billion in debt. Despite the residual effects of this failure, for one broker, the torment is finally over. On April 7, 2014, Edward Graham Dulin, Jr. was awarded a $5.4 million award to compensate him for the diminution in the value of his career and the damage to his business from being held responsible for losses sustained by investors to whom he had recommended the purchase of Lehman Principal Protected Structured Products (“Structured Products”). UBS’ actions led to the disclosure of thirty-nine (39) customer complaints on Mr. Dulin’s Central Registration Depository records – forms U4 and U5.

The hearing lasted twenty-one days and involved two experts, Dr. Craig McCann and Terry Ormsbee, and thousands of exhibits. The theory of the case focused on the knowledge of UBS compliance officers and managers at the time the products were sold in 2007. UBS attempted to assert that its compliance officers and managers were unaware of the instability of Lehman Brothers and the risks associated with the Structured Products. Nevertheless, Seth Lipner, counsel for Mr. Dulin, was able to show UBS’s knowledge of the failings of Lehman Brothers in 2007 through his examination of UBS employees and presentation of documentary evidence. [The original version of this post incorrectly identified Mr. Lipner as a witness in the proceeding. The IRC apologizes for any confusion caused by the incorrect information in its original post.] Mr. Lipner was further able to present evidence of UBS’s express decision to not cause any panic amongst the brokers by not informing them of this information. Shockingly, UBS compliance officers and managers did not correct any misunderstandings even after the broker in question communicated his misunderstanding via e-mail.

The evidence established that the compliance officers and managers did not understand the product and did not understand the implications of their actions. These misunderstandings were transferred onto the customers by providing them with inaccurate sales materials and free writing prospectuses. The decision to remain mute as to the risks led to dozens of customer complaints and millions in losses.

Mr. Dulin asserted the following causes of action: Intentional Interference with Business Expectancy, Injurious Falsehood, Breach of Contract, and Violation of Arizona Securities Statutes and Regulations. The hearing resulted in an award for the broker of $4 million in compensatory damages, $1 million in punitive damages, $250,000 in attorneys’ fees, $85,000 in costs, $52,000 in arbitrator fees. The panel even recommended the expungement of all thirty-nine (39) of the customer complaints against the broker.

Investors Eager for Puerto Rico’s $70 Billion Debt?

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By Fernando Langa

The Puerto Rican economy has significantly suffered because of the territory’s $70 billion debt.  The debt has constrained the island, which has been in recession since 2006, crimping tax revenue and pushing the jobless rate well into double digits.

Rating agencies have reacted to the territory’s economic crisis.  On February 2014, Standard & Poor, Moody’s, and Fitch downgraded Puerto Rico’s debt to junk status.  Standard & Poor believed that liquidity constraints did not warrant an investment grade rating.  Puerto Rican officials and market analysts believed that Puerto Rico would face significant challenges in obtaining any type of investments because of the economy’s inability to portray any type of recovery.

However, on March 11, 2014, Puerto Rico issued $3.5 billion of general-obligation bonds and received more than $16 billion in orders.  Hedge fund managers who received half the amount they requested considered themselves lucky.  Market advisors believe that the fears of widespread default are misplaced.  Moreover, these bonds are tax-exempt and are yielding at 8.73%, which is double the rate of general municipal bonds. Since the last quarter of 2013, Puerto Rico has implemented measures that have already had an impact on the economy: increasing retirement age, raising taxes, and cutting bonuses for public officials.

FINRA is currently examining the trading and demand for these bonds.  The prospectus for the bonds states that the debt would be issued in minimum denominations of $100,000 unless Puerto Rico’s credit rating was upgraded.  However, recent activity shows that the bonds are trading in denominations as low as $5,000.  FINRA fears that these bonds, which are junk-rated, are currently being sold to individual investors as safe, conservative investments (which they are not).

Because Puerto Rico is relying on the credibility and success of these bonds to improve its credit rating and attract investors to its territory, it will be quite unfortunate if FINRA finds some type of violation in the trading of these bonds.

FINRA Announces New Focus on Cockroaches – Recidivist Offenders in the Securities Industry

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By Alexander Cook

Cockroaching is an aptly crass name for a behavior in which some of the most devious brokerage firms and brokers have engaged.  The name is given to a pattern of conduct in which less-than-ethical brokers move between less-than-ethical brokerage firms at a rapid pace, allowing them to more effectively avoid detection while repeatedly perpetrating the same type of crimes.

In a January 2, 2014 regulatory letter to members, FINRA announced the expansion of the High Risk Broker program and the creation of a six-member enforcement team devoted to prosecuting such cases.  In its release, FINRA announced that “A small number of brokers have a pattern of complaints or disclosures for sales practice abuses and could harm investors as well as the reputation of the securities industry and financial markets.”  An October 2013 Wall Street Journal exposé demonstrated that from 2005 until the end of 2012, FINRA had expelled 173 brokerage firms for wrongdoings which ranged from the firm’s refusal to pay regulatory fines to fraud committed by individual brokers.  Of the brokers employed by those firms, more than 5,000 were still licensed to sell securities in 2013.  Most startlingly, about 12% of those brokers had been employed by at least two of the expelled firms.  In one case described by the Wall Street Journal, a single broker moved between expelled firms at least ten times in little more than a decade.  The report also found that many cockroaching brokers continued to trade securities even after being involved in several arbitrations or declaring bankruptcy multiple times.  This cockroaching has now been red flagged by FINRA subsequent to the January 2014 announcement, resulting in a heightened examination process in which FINRA “will review the firm’s due diligence conducted in the hiring process, review for the adequacy of supervision of higher risk brokers, […] and […] place particular focus on these brokers’ clients’ accounts in conducting reviews of sales practices.”

Beyond simply fearing that a few brokerage firms may condone unethical behavior, FINRA also proclaimed anxiety that the small percentage of cockroach brokers in the securities industry may pollute the culture of formerly ethical firms by bringing their illegal practices with them.  For instance, the WSJ found that brokers who had left at least two previously expelled firms averaged more than eight times as many arbitration claims against them compared to the rest of the industry.  Moreover,  an October 2013 PIABA study which found that roughly $50 million of arbitration awards are left outstanding every year, as offending firms often shutter their business and allow transgressing brokers to drift to more innocuous firms.  The outcome for investors is lost capital with little to no recourse against the offenders.  FINRA’s renewed attempt to track, investigate, and halt cockroaching brokers before they have the chance to do more damage is certainly admirable and commendable.  Of the dozens of issues and problems FINRA regularly deals with, eliminating recidivist brokers and firms should be one of the most solvable.  There is no justification for allowing unethical brokers to remain brokers simply because they are able to outsmart the regulatory system; finally the regulatory system may be outsmarting them.

One Size Does Not Fit All: Supervisory Failures Added to Risks Associated with REITs

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By Katia Ramundo

On March 24, FINRA announced that it hit LPL Financial with a fine of $950,000 for supervisory deficiencies in the sales of alternative investments. According to FINRA, the deficiencies are related to sales of a broad range of products, including non-traded REITs, oil and gas partnerships, business development companies, hedge funds, managed futures, and other illiquid investments.

FINRA found that between January 1, 2008, and July 1, 2012, LPL Financial violated NASD Rule 3010(a) and 3010(b), NASD Rule 2110 and FINRA Rule 2010 by failing to properly supervise the sale of alternative investments that violated investor concentration limits set forth both at the state level and by LPL itself. LPL created its own automated review system, but the database was not frequently updated to accurately reflect suitability standards. This often meant relying on outdated and inaccurate information. FINRA also stated that LPL failed to adequately train its supervisory staff to properly analyze state standards within their suitability reviews of such products.

REITs, and other alternative investments, may be good for the sales representative, but this does not mean they are suitable for every investor. Various securities regulators have been scrutinizing non-traded REITs sales at LPL for the past year and a half. The firm was one of the six broker-dealers that eventually settled with the Massachusetts Secretary of State and the Massachusetts Securities Division over these sales practices, agreeing to pay $4.8 million in restitution to clients.

REITs are of interest to investors because of their high dividend yield, simple tax treatment, and diversification. However, investors should be cautious of these selling points and balance them against numerous risks and complexities that these investments carry. The values of the REIT shares and dividends depend on the strength of the real estate market. In a bad commercial real estate market, rising vacancy rates would cut into income collected by the REIT, which would reduce the size of dividends offered. FINRA warns that older investors should be particularly cautious about investing large portions of their retirement income in non-traded REITs because the initial investment in a non-traded REIT is not guaranteed and may increase or decrease in value at any time.

Before investing in REITs and various other alternative investments, investors should properly assess their risks. FINRA has started to help underserved investors that have been improperly placed in these highly volatile investments, but investors should also do their part by staying informed. Investors should always inspect a REIT’s website, stay updated on the REIT’s dividend payment history and fees, and should also read the REIT’s prospectus.

High Frequency Trading Has the FBI Investigating Whether the Stock Market Is Rigged

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By Ted J. Krapin

The Federal Bureau of Investigation has joined several authorities, including the U.S. Securities and Exchange Commission, Commodity Futures Trading Commission, and New York State Attorney General Eric Schneiderman, in investigating whether high frequency trading (“HFT”) firms break U.S. laws by acting on private information aggregated by super-fast computers in order to gain an edge over their competitors. The FBI has openly solicited traders and stock-exchange workers to blow the whistle on possible front running and market manipulation by HFT firms. The investigation stems from a multi-year crackdown on insider trading that has resulted in 79 convictions of hedge-fund traders.

HFT firms use super-fast computers and algorithms to trade securities at rates measured in thousandths or even millionths of a second to capture price discrepancies and arbitrage opportunities. HFT accounts for approximately 50% of the U.S. equity trading volume and 40% of equity trades in Europe.

The FBI investigation focuses on whether HFT firms are able to take advantage of sophisticated computers by gathering orders placed by institutional investors moments before the order is filled and using the information to place or cancel orders at a different price. Through HFT, insiders are able to legally front run retail orders by seeing a desire to buy shares, acquiring them in front of investors, and then selling them back at higher prices to achieve immediate profits.

Michael Lewis, one of the most-read authors on Wall Street, examines HFT in his new book, Flash Boys: A Wall Street Revolt. In Flash Boys, Lewis outlines HFT, rationalizes that the market is “rigged” and that everyone who owns equities is victimized, and provides examples to show how lucrative HFT can be. One example is of a technology firm that spent $300 million to build a line that cut three milliseconds off the time it takes to communicate between New Jersey and Chicago, and leased the line out to several securities companies for $10 million each.

Lewis also devotes a portion of Flash Boys to Brad Katsuyama, a former trader for Royal Bank of Canada. In 2008, Katsuyama noticed that every time he tried to purchase a large block of stock for a client, the order would only partially be filled and the price of the stock would increase for subsequent portions of the order.

Katsuyama assembled a team of experts and discovered that the market manipulation was made possible by the way trades were routed through fiber-optic cables in exchanges outside of Manhattan. Katsuyama figured out that he could prevent losses from high frequency trading by sending trades to the farthest possible exchanges. He subsequently developed his own exchange, IEX, now used by a number of major hedge funds and investment banks to thwart the effects of high-speed trading.

FINRA May Collect Massive Amounts of Confidential Customer Data in the Future

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By Tanner Forman

FINRA has proposed the creation of a new form of market regulation known as the Comprehensive Automated Risk Data System (“CARDS”).  If the system is created, FINRA would be allowed to mine massive amounts of client data from investment firms in hopes of using that data to better protect investors and to detect and fight risks that could cripple firms and the market.  A FINRA regulatory notice published in December of 2013 provides, “the CARDS system would download customer trade data from clearing firms and analyze it to identify churning, pump-and-dump schemes, excessive markups and mutual fund switching.”  FINRA believes that the system would help it deter both investment firms and brokers from engaging in questionable behavior.

However, not everyone shares FINRA’s same enthusiasm for the CARDS system.  The brokerage industry is hoping to convince FINRA that the system would cause too many privacy concerns.  What the brokerage industry isn’t saying is that the industry is opposed to the system because the increased oversight could uncover broker misconduct and could harm the investment firms’ overall profits.

Some investors are also opposed to the creation of the CARDS system because of the system’s apparent resemblance to the data collection process of the National Security Administration.  In particular, investors are concerned with the idea of FINRA possessing large amounts of sensitive data.  If there was a breach in the security of the database, a hacker could have access to highly confidential customer financial information, including holdings and transactions.  Unauthorized access to that information could cause serious damage to individual customers and to the overall confidence in the stock market.

At this point, CARDS is only a concept and not a formal rule proposal.  FINRA solicited comments on the CARDS system with the deadline to comment expiring on March 21, 2013.  It will be interesting to see whether FINRA creates the CARDS system and whether the system’s higher risk will lead to higher returns in regard to market regulation.