Skip to main content


Representing Individual, High Net Worth & Institutional Investors

Offices in Indiana and New York City


Home > Blog > Monthly Archives: November 2011

Monthly Archives: November 2011

Next Financial to Reimburse Clients $2 Million in Provident Royalties Case

Private-placement lawsuits and investigations continue to make their presence known, much to the chagrin of the broker/dealers that touted some soured deals involving Provident Royalties. The latest B-D to face the music is Next Financial Group, which will pay $2 million in restitution to customers who purchased oil and natural gas private placements of Provident Royalties.

According to the Financial Industry Regulatory Authority (FINRA), Next Financial sold $20 million of three separate Provident private placements from July 2008 to January 2009. During that time, Next Financial’s due diligence was lacking, FINRA said.

“Despite the fact that Next received a specific fee related to the due diligence that was purportedly performed in connection with each offering, beyond reviewing the private-placement memorandum for the offerings, [Steven Nelson, vice president of investment products and services] did not perform adequate due diligence on the [Provident] offerings,” according to FINRA.

Two years ago, the Securities and Exchange Commission (SEC) charged Provident with fraud.

As reported Nov. 28 by Investment News, outside due diligence reports highlighted a number of red flags regarding the Provident offerings, as well as the fact that Next Financial and Steven Nelson “should have scrutinized each of the [Provident] offerings, given the purported high rate of returns.”

About 50 broker/dealers sold private placements in Provident, which raised $485 million from 7,700 investors between 2006 to 2009. At least 20 broker/dealers that sold Provident private placements have shut down or declared bankruptcy.

FINRA also levied fines of $50,000 on Next Financial and $10,000 on Nelson, who was suspended as a principal for six months.

Sloppy Due Diligence Behind Private-Placement Deals

Private placements have been a ongoing source of controversy – not to mention financial losses for investors – this year, with regulators filing fraud charges against issuers like Medical Capital Holdings and Provident Royalties.

Now a well known forensic accountant says that the broker/dealers behind the doomed private-placement deals failed miserably in their due-diligence responsibilities to investors.

As reported Nov. 25 by Investment News, Gordon Yale, a certified public account and principal of Yale & Co., contends that broker/dealers’ due diligence showed incredible “sloppiness” when touting private placements in Medical Capital and Provident. According to Yale, the actions by the broker/dealers exhibited the “same recklessness with which major investment banks conducted their mortgage-backed-securities business, but it was done by middle- or lower-tier firms and [with] a different set of products.”

Over the past year, regulators have issued several fines and sanctions against various broker/dealers that sold private placements in Medical Capital Holdings, Provident Royalties, and DBSI tenant-in-common exchanges. In September, the Financial Industry Regulatory Authority (FINRA) imposed a $10,000 fine and a six-month suspension against Brian Boppre, former president of Capital Financial Services. Capital Financial was a top seller of both Medical Capital and Provident Royalties notes. Both companies were charged with fraud by the Securities and Exchange Commission in 2009.

Wells Timberland REIT Fined by FINRA for Misleading Marketing

Another non-traded REIT has landed in hot water with regulators. The Financial Industry Regulatory Authority (FINRA) imposed a $300,000 fine against Wells Investment Securities over misleading marketing tied to Wells Timberland REIT.

In reaching the settlement, Wells Investment Securities neither admitted nor denied the charges.

According to FINRA, communications from Wells Securities about Wells Timberland contained misleading statements regarding its portfolio diversification, as well as its ability to make distributions and redemptions.

“By approving and distributing marketing materials with ambiguous and equivocal statements, Wells misled investors into thinking Wells Timberland was a REIT at a time when it was not a REIT,” said FINRA executive vice president and chief of enforcement Brad Bennett in a statement.

FINRA also found that Wells failed to have proper supervisory procedures in place to ensure that sensitive customer and proprietary information stored on laptops was adequately safeguarded.

As reported Nov. 22 by Investment News, this is not the first time that Wells Securities has had a run-in with regulators over REITs. In October 2003, FINRA’s precursor, NASD, sanctioned Wells Investment Securities for improperly rewarding broker/dealer representatives who sold the company’s REITs. Those rewards included lavish entertainment and travel perquisites. FINRA also censured Leo Wells, founder and chairman of Wells Real Estate Funds, suspending him from acting in a principal capacity for one year.

Wells Real Estate Funds is one of the largest sponsors of investments in the non-traded REIT industry, with $11 billion in assets and 250,000 investors.

Morgan Stanley Pinnacle Notes Lawsuit to Move Forward

A federal judge has decided that Morgan Stanley must face the music and defend itself in a lawsuit brought by 18 Singapore investors over failed structured products. Among the allegations, investors accuse Morgan Stanley of committing fraud in 2006 and 2007 when it sold them nearly $155 million of Pinnacle Notes structured products. The notes, which were linked to synthetic collateralized debt obligations (CDOs), lost almost 100% of their value amid the financial crisis.

Morgan Stanley tried to get the lawsuit dismissed, but District Judge Leonard Sand rejected its request.

“Defendants point to generalized warnings cautioning investors not to rely solely on the offering materials,” Judge Sand stated in this ruling. “But even a sophisticated investor armed with a bevy of accountants, financial advisors and lawyers could not have known that Morgan Stanley would select inherently risky underlying assets and short them.”

As reported Nov. 4 by Reuters, the October 2010 lawsuit is seeking class-action status. It is one of several lawsuits accusing banks of misleading investors into buying supposedly safe securities backed by risky debt, even as other investors or the banks themselves were actually shorting them.

In the Morgan Stanley case – Dandong et al. vs. Pinnacle Performance Ltd et al., U.S. District Court, Southern District of New York, No. 10-08086 – plaintiffs allege that the bank represented the Pinnacle Notes as “conservative” and that they would keep their principal safe.

Instead, Morgan Stanley allegedly invested their money into synthetic CDOs that were tied to risky companies. In addition, investors say they were kept in the dark to the fact that Morgan Stanley acted as a counterparty in the CDO deal whereby it collected one dollar for every dollar investors lost.

“Morgan Stanley designed the synthetic CDOs to fail,” the complaint said. “It placed itself on the side guaranteed to win (the “short” side) and placed plaintiffs and the class on the side guaranteed to lose (the “long” side).”

The Ongoing Dangers of Synthetic ETFs

Synthetic exchange-traded funds (ETFs) have gotten a bad rap lately – and with good reason. Regulators and many financial experts believe that synthetic ETFs are too complex for retail investors and that they may not fully understand the counterparty and derivatives risks they are actually taking on.

Many synthetic exchange-traded funds rely on derivatives to generate returns instead of holding or owning the underlying securities as traditional ETFs do. Synthetic ETFs include inverse and leveraged funds. A leveraged ETF is designed to accelerate returns based on the rate of growth of the index being tracked. For example, if the underlying index moves up 3%, a 2x leveraged ETF would move up by 6%.

An inverse ETF does the opposite. It is designed to perform as the inverse of whatever index or benchmark is being tracked. Inverse ETFs funds work by using short selling, derivatives and other techniques involving leverage.

And with leverage, there always comes risk. As reported Nov. 17 by Investment News, Laurence D. Fink, chief executive officer of BlackRock, Inc., is a staunch critic of some exchange-traded funds. In particular, Fink takes issue with ETFs provided by Societe Generale SA.

“If you buy a Lyxor product, you’re an unsecured creditor of SocGen,” said Fink in the Investment News story. Providers of synthetic ETFs should “tell the investor what they actually are. You’re getting a swap. You’re counterparty to the issuer.”

And therein is the problem.

Counterparty risk means there is a chance that the swap provider could go belly up, leaving investors out in the cold. Remember Lehman Brothers? Following Lehman’s collapse in 2008, many investors quickly discovered that their investments were essentially worthless.

Regulation 1.25: The Undoing of MF Global?

The headline says it all: “Purgatory For MF Global Customers.” The story, appearing Nov. 16 in the Wall Street Journal, highlights the aftermath of MF Global’s bankruptcy filing and the consequences now facing MF Global clients.

MF Global filed for Chapter 11 bankruptcy on Oct. 31. More than two weeks later, some 33,000 customers are unable to access their money – “stuck in a sort of purgatory.” And it’s possible that customers may never get all of their money back.

“My entire business has come to a halt,” said Andrew Gochberg in the Wall Street Journal article. “I’m angry and I no longer have any confidence in our system.”

Gochberg had more than more than $1 million with MF Global – in what he and thousands of other investors thought were safe, protected accounts and accounts kept separate from MF Global’s own money.

But that apparently didn’t happen. After MF Global filed for bankruptcy protection, regulators discovered more than $600 million missing in customer money.

How did it happen? That’s the $64,000 – or, in MF Global’s case, the $600 million-dollar – question. It may have something to do with a little known finance rule called Regulation 1.25. Before 2000, the rule allowed futures brokers to take money from their customers’ accounts and invest that money in approved, relatively safe securities with high liquidity.

But, as reported in a Nov. 16 story by Bloomberg, things changed in December 2000 when the Commodities Futures Trading Commission amended Regulation 1.25. Now investments were permitted in “general obligations issued by any enterprise sponsored by the United States, bank certificates of deposit, commercial paper, corporate notes, general obligations of a sovereign nation, and interests in money market mutual funds.” In short, riskier investments were now allowed under Regulation 1.25.

More changes came in February 2004 and May 2005, with Regulation 1.25 amended even further so that firms like MF Global could do “internal repos” of customers’ deposits – i.e. take money from customer accounts and invest that money in the short term in a variety of high-risk securities.

And that, of course, ultimately led to the undoing of MF Global and the beginning of a financial nightmare for its clients.

JPMorgan Chase Fined $1.7M Over Risky, Unsuitable Investments

JPMorgan Chase & Co. has been ordered by the Financial Industry Regulatory Authority (FINRA) to reimburse customers more than $1.9 million for losses that occurred from unsuitable investment recommendations. The firm also has to pay a fine of $1.7 million.

According to FINRA, brokers with Chase Investment Services Corp. made nearly 260 unsuitable investment recommendations involving UITs and floating-rate loan funds to unsophisticated customers with little or no investment experience and who had conservative risk tolerance. As result of the investments, Chase customers suffered losses of about $1.4 million.

FINRA also found that Chase failed to implement supervisory procedures to reasonably supervise its sales of UITs and floating-rate loan funds.

A UIT is an investment product that consists of a diversified basket of securities, which can include risky, speculative investments such as high-yield/below investment-grade or “junk” bonds. Floating-rate loan funds are mutual funds that generally invest in a portfolio of secured senior loans made to entities whose credit quality is rated below investment-grade, or “junk.”

Elderly Are Easy Victims When It Comes to Investment Fraud

Seniors are often an easy target for investment fraud – so much so that the Financial Industry Regulatory Authority (FINRA) is warning some broker/dealers about the use of designations that may imply special expertise in working with elderly investors.

In a regulatory notice issued earlier this month, FINRA reminded firms of their supervisory obligations regarding how they use certifications or designations that imply expertise, training or specialty in advising senior investors. The notice also outlines findings from a survey FINRA conducted with broker/dealers and their use of senior designations.

Among other things, findings from the survey showed that some supervisory procedures were not discerning enough when it came to the quality of the designations. And, in some cases, the senior designations approved by various broker/dealers did not require rigorous qualification standards.

As reported Nov. 15 by Investment News, regulators have been concerned for some time now regarding the use of senior designations, as well as the marketing practices used by many broker/dealers to sell products to elderly investors. One of those practices is the “free-lunch seminar,” which has often been used to lure people – especially the elderly – into investing in unsuitable or even fraudulent products.

According to the Securities and Exchange Commission (SEC), these types of lunches are typically held at upscale hotels, restaurants, retirement communities and golf courses. In addition to providing a free meal, the firms and individuals conducting the gatherings often use other incentives such as door prizes, free books, and vacation deals to encourage attendance. The real purpose of the meetings, however, is often to entice attendees’ to open new accounts with the sponsoring firm and, ultimately, in buy into the investment product being touted.

The most commonly discussed products at the sales seminars include private placements, variable annuities, real estate investment trusts, equity indexed annuities, mutual funds, private placements of speculative securities (such as oil and gas interests) and reverse mortgages, the SEC says.

MF Global Clients Unable to Get Their Cash

The meltdown of MF Global has left countless investors out in the cold, unable to access their now-frozen accounts.

As of Oct. 31, when MF Global’s parent company – MF Global Holdings – filed for bankruptcy protection, more than 150,000 customer accounts were frozen. The sudden turn of events occurred after MF Global announced it had lost money on a number of bad bets related to derivatives contracts.

The Commodity Futures Trading Commission is continuing its investigation into the collapsed brokerage, after discovering that some $600 million was missing in accounts held by MF Global clients.

On Friday, Nov. 11, MF Global laid off 1,066 employees, keeping only a skeleton staff to help with the dissolution of its business. Employees were notified of the layoffs in town hall meetings at MF Global’s offices in Manhattan and in Chicago, according to the New York Times. Jon Corzine, MF Global’s former CEO, announced his resignation earlier this week.

The MF Global bankruptcy is the eighth-largest bankruptcy ever.

Meanwhile, a federal statute designed to protect customers of failed brokerages may not be able to help MF Global’s commodities customers if the trustee in the case – James W. Giddens – is unable to locate the $600 million in missing customer money.

That leaves more questions for MF Global clients – and fears they may never see their money again.

Inverse/Leveraged ETFs a Concern For Investors

What’s wrong with inverse or leveraged exchange-traded funds (ETFs)? Plenty, if you don’t fully understand how the products actually work or the risks involved.

Inverse or leveraged exchange-traded funds are considered synthetic funds, and they are complicated products that often entail much more risk than traditional ETFs. Leveraged ETFs use “borrowed” money in the form of swaps or derivatives to double or triple the daily returns on a stated index. Inverse ETFs do the opposite. Instead of tracking the fund to the performance of an index, the price of an inverse ETF moves in a direction opposite to the daily movement of its index.

In the past year, synthetic funds have come under growing scrutiny by regulators over concerns that investors may not be aware of the risks that the products pose. Earlier this summer, the Financial Industry Regulatory Authority (FINRA) issued a regulatory notice on leveraged and inverse ETFs. Among other things, FINRA said that the complexity of inverse and leveraged ETFs made them unsuitable for any retail investor who planned to hold on to them for longer than one trading session.

Unfortunately, many investors failed to heed FINRA’s warning because their advisors never thoroughly explained the fine print associated with leveraged and inverse exchange-traded funds. Instead, investors held their investments for much longer periods of time, only to see returns that were vastly different from what they were promised by their financial advisers. This particular scenario has become more frequent over the past year as volatility in the financial markets made performance surprises in the ETF market the norm rather than the exception.

The bottom line: If you’re thinking about investing in leveraged or inverse exchange-traded funds, think long and hard before taking action.

Top of Page