Monthly Archives: August 2009

The widow of a 77-year-old man has filed an arbitration claim with the Financial Industry Regulatory Authority (FINRA) against Ameriprise Financial Services on allegations an Ameriprise broker failed to appropriately advise her elderly husband about a variable annuity purchase and further botched the beneficiary designation on the investment.

According to the claim, Deborah Amilowski, a broker with Ameriprise’s Hauppauge, New York office, recommended an unsuitable RiverSource variable annuity as an initial investment to the woman’s husband. As reported Aug. 27 by Investment News, when the client purchased the annuity in 2005, he was over the maximum age allowed for the guaranteed death benefit. As a result, any heirs would only be eligible to receive the market value of the annuity at time of his death, according to the claim.

The investor placed $850,000 into the annuity over a one-year period, according the Investment News article.

The original beneficiary on the annuity was an irrevocable trust, according to the claim, but the investor had instructed the Ameriprise broker to change the beneficiary designation to a revocable trust. Ameriprise reportedly informed the client (whose name has not been released) that his change request had been fulfilled. However, at the time of his death in March 2008, his family discovered that the change never made it to processing.

During the time that Ameriprise investigated the beneficiary designation issue, the account’s value went from more than $1 million to a little more than $750,000. The annuity was liquidated in October, 2008.

The widow is seeking damages for the unsuitable annuity recommendation, as well as for Ameriprise’s alleged negligence in failing to either pay out the benefit in a timely manner or to protect the annuity’s value.

Marcus Schrenker was Indiana’s own version of Bernie Madoff. Before his arrest in January, Schrenker had built a successful investment advisory business off of the money and trust of family and friends. Behind the scenes, however was a different story, with Schrenker selling nonexistent foreign currency funds, creating false account information, and using clients’ money to fund a lavish lifestyle that included a private plane and a luxurious lakeside estate. On Aug. 19, during federal sentencing in Pensacola, Fla., Schrenker was given 51 months in prison for charges stemming to the Jan. 11 plane crash in which Schrenker tried to fake his own death near Florida.

Schrenker’s legal issues are far from over, however. He still faces 11 felony counts related to his investment businesses in Indiana.

Schrenker’s victims include his aunt, Rita Schilling, who transferred more than $200,000 to one of Schrenker’s investment companies in August 2008. Another victim is a long-time friend, Charles Black. In 2004, Schrenker moved $100,000 out of Black’s account without his consent, according to a probable cause affidavit.

As in the case of Bernie Madoff, Schrenker’s roster of clients never became suspicious of the Indiana money manager because they knew him personally or had been introduced to him by people they trusted. Also like Madoff, Schrenker’s facade of investing prowess was aided by personal images of wealth and success.

Two Nobel laureates have entered into the valuation debate and are calling upon financial institutions to provide a more accurate portrait of their illiquid assets to investors. Robert Merton first commented on the issue in a column for the Financial Times on Aug. 18 in which he said banks that opposed mark to market accounting were simply looking to conceal depressed prices.

Myron Scholes echoed those comments in an Aug. 19 interview with Bloomberg, with both men urging banks to mark more securities to market and put any hard-to-value securities on public exchanges wherever possible.

According to Scholes and Merton, such a move would give investors better data on prices to more accurately reflect the value of an institution’s debt and equity securities.

Scholes and Merton shared the Nobel Prize for economics in 1997 for helping invent a model for pricing options. They also learned about the danger of leverage firsthand. Merton and Scholes were the creators of Long-Term Capital Management, whose collapse in 1998 was the largest-ever hedge fund failure at the time.

At one point, Long-Term Capital Management held more than $100 billion in assets. However, the firm was highly leveraged, borrowing billions to make big bets on esoteric securities. When the markets took a turn for the worse in 1998, the bets backfired and Long-Term Capital Management lost most its money. Fearing that its collapse could set off a full-scale market meltdown, the U.S. Federal Reserve stepped in to orchestrate a bailout by 14 lenders.

Ironically, there was only one naysayer among the 14 banks that agreed to the rescue: Bear Stearns.

Leveraged and inverse exchange-traded funds (ETFs) have come under fire recently for the potential dangers these complex financial products may hold for individual investors. ETFs are designed to capture two or three times the movement in a particular stock index or, in the case of an inverse ETF, provide results that are 100% opposite. In the current economic climate, however, many investors are discovering huge distortions in the stated performance objectives of these investments.

The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) both issued investor alerts recently on leveraged and inverse ETFs, cautioning individuals about the investing pitfalls these highly specialized and complex products can create.

Specifically, leveraged and inverse ETFs provide leverage on a daily basis. Many investors fail to understand this concept and, instead, wind up buying an ETF and holding it for a year, which can put them at a huge financial risk.

In a recent SEC alert, two real-life examples were depicted of how returns on a leveraged or inverse ETF over longer periods of time can be widely different from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time.

Example 1: Between December 1, 2008, and April 30, 2009, a particular index gained 2%. However, a leveraged ETF seeking to deliver twice that index’s daily return fell by 6% – and an inverse ETF seeking to deliver twice the inverse of the index’s daily return fell by 25%.

Example 2: During that same period, an ETF seeking to deliver three times the daily return of a different index fell 53%, while the underlying index actually gained around 8%. An ETF seeking to deliver three times the inverse of the index’s daily return declined by 90% over the same period.

The SEC’s advice to individual investors who may be considering a leveraged or inverse ETF is to thoroughly do their homework. Make sure to understand the ETF’s stated objectives, as well as its potential risks. It’s also important to know that leveraged or inverse ETFs may be more costly in terms of fees than traditional ETFs. FINRA’s Fund Analyzer can estimate the impact of fees and expenses on your investment.

In addition, there can be significant tax consequences associated with leveraged or inverse ETFs that are less tax-efficient than traditional ETFs.

In the face of regulatory inquiries and pronouncements by the Financial Industry Regulatory Authority (FINRA) on the inherent risks they pose to retail investors, more brokerages are curtailing their activity in leveraged and inverse exchange traded funds (ETFs).

FINRA initially raised questions about inverse and leveraged ETFs when it issued a notice to brokers/dealers on June 11, cautioning them that the instruments may not be suitable investments for retail investors who plan to hold onto the instruments for more than one trading session.

Shortly after FINRA’s edict, Saint-Louis based Edward D. Jones announced its intent to halt sales of leveraged ETFs. UBS and Ameriprise soon followed. Other brokerages, including Charles Schwab, Raymond James Financial and LPL Financial are reviewing their policies concerning ETFs, with some firms posting information on their respective Web sites that inverse and leveraged ETFs “are not right for everyone.”

Leveraged ETFs allow investors to amplify bets on a wide range of markets, while inverse ETFs make profits when prices fall.

Many investors, however, are unaware about the complexities and underlying risks of inverse and leveraged ETFs. Leveraged ETFs, for example, are designed to deliver their stated leverage on a daily basis. If an investor holds the ETF longer than one trading session, it potentially could lead to financial disaster. Leveraged ETFs also employ, as their name implies, leverage. This, in turn, increases the level of financial risk for investors.

On August 5, a lawsuit involving ETFs was filed in New York, accusing ProShare Advisors LLC and others of violating a securities act by failing to disclose the risks of its ProShares UltraShort Real Estate fund (SRS). Among the risks that the complaint contends the inverse leveraged exchange traded fund failed to cite: “Spectacular tracking error.”

Specifically, the lawsuit alleges that the fund’s index fell 39.2% from January 2008 to December 2008, but the fund fell 48.2%, which was not in accordance with ProShares’ stated objective that UltraShort ETFs go up when markets go down.

The complaint is seeking class-action status, according to an Aug. 6 article in the Wall Street Journal.

The dramatic losses of the SRS fund reiterate the inherent risks posed by inverse and leveraged ETFs, especially in times of a volatile market. In the 12 months through July 23, the Dow Jones U.S. Real Estate Index shed 38%, but the ProShares UltraShort Real Estate fund lost 82%, according to the Wall Street Journal article. This year through July 23, the index is down 3.5%, but the fund has slipped 67%.

The devil is in the details. This is especially true for leveraged and inverse exchanged traded funds, or ETFs. These aggressive and complicated financial products have evolved from straightforward instruments to funds that use baskets of derivatives and risky credit swaps to provide inverse, leveraged, leveraged-inverse, and commodity-linked returns. Unlike traditional ETFs, inverse and leverage ETFs have “leverage” inherently embodied into their product design. Translation: Increased risks for investors.

Leveraged ETFs use credit swaps or derivatives to amplify daily index returns, while inverse ETFs are designed to profit from a decline in the value of the underlying assets that the fund mirrors. This could be a stock index, currency, commodity or specific industry sector like real estate. If the underlying index declines by 1%, the inverse ETF should, in theory, increase 1% on that same trading day.

Investing in leveraged and inverse ETFs can be tricky, not to mention potentially dangerous for the average investor. These types of ETFs are meant to reflect the underlying asset moves on a daily basis. When held longer for a day, the end result can spell financial disaster.

Leveraged and inverse ETFs are big business for investment firms and financial advisers. Assets in leveraged and inverse funds increased 51% this year, reaching $32.8 billion. This explosive growth prompted the Financial Industry Regulatory Authority (FINRA) to issue a warning to brokers in June that leveraged and inverse ETFs may not be an appropriate investment for long-term investors because returns can deviate from underlying indexes if held for longer than a day.

Since then, several investment firms have halted their sales of leveraged ETFs. Among them: UBS, Edward Jones and Ameriprise Financial.

Yesterday, a class-action lawsuit was filed against ProShares – one of the top sellers of inverse and leveraged ETFs – over one of its inverse leveraged exchange traded funds. According to the complaint, the ProShares UltraShort Real Estate fund did not disclose a series of risks associated with the fund, including a “spectacular tracking error.” The lawsuit also says the company markets its leveraged funds as “simple directional plays.”

The ProShares UltraShort Real Estate fund was designed to deliver amplified returns against an index, which in its case was the Dow Jones Real Estate Index. The returns were supposed to be twice the opposite of that index. In 2008, however, the index fell 39%, yet the fund fell 48%.

Federal prosecutors say former Credit Suisse Group AG broker Eric Butler used bait-and-switch tactics to fraudulently steer institutional and retail clients into millions of dollars worth of auction-rate securities, collateralized debt obligations (CDOs) and other risky debt instead of the safe, conservative investments the investors initially asked for. On Aug. 14, after only two hours of jury deliberations, Butler was found guilty of conspiracy to commit securities fraud, securities fraud and conspiracy to commit wire fraud. He faces a maximum sentence of 20 years in prison on the most serious count.

Butler’s co-defendant is Julian Tzolov, who had fled the country earlier this year. He was returned to the United States on July 20 and has since pleaded guilty to conspiracy, wire fraud and securities fraud. His is awaiting sentencing.

Butler and Tzolov were charged in September of lying to clients about their purchases of nearly $1 billion of auction-rate securities and CDOs from 2004 to 2007. Reportedly, the two men had told customers their investments were backed by federally guaranteed student loans.

During Butler’s trial, Tzolov served as a witness for the prosecution, providing testimony against his former partner.

“We did it together,” Tzolov told jurors. “We were sitting right next to each other. We were meeting with clients together.”

In the wake of the collapse of the auction rate securities market in February 2008, many of the nation’s largest financial institutions quickly agreed to settlements with state securities regulators as a way to resolve charges they misled retail and institutional investors about the liquidity risks of the instruments they underwrote.

The latest state to order a Wall Street institution to buy back auction rate securities from investors is Pennsylvania, which on Aug. 11 ordered Wells Fargo & Co.’s Wachovia unit to buy back $324.6 million of auction rate securities from an estimated 1,300 Pennsylvania retail investors.

Wachovia also will pay a $2.52 million assessment to the state for its role in the auction rate securities market.

In a press release on the ARS agreement with Wachovia, Pennsylvania Securities Commissioner Steven Irwin said the bank “marketed and sold these securities as safe, liquid and cash-like investments when, in fact, they were long-term investments subject to a complex auction process that failed in early 2008, leading to illiquidity and lower interest rates for investors.”  

The Pennsylvania Securities Commission is continuing its investigation of other investment firms and their sales of auction rate securities. In July, the regulator ordered TD Ameritrade to repurchase $26.5 million of auction-rate securities. That same month, Pennsylvania also reached a settlement with Citigroup over ARS sales. That settlement, which was part of a larger deal agreed to with 12 states, required Citigroup to buy back $978.1 million worth of auction rate securities from Pennsylvania investors. In addition, Citigroup paid a $2.31 million fine to the Pennsylvania Securities Commission.

Former BusinessWeek writer Matthew Goldstein hit the nail on the head in his Aug. 11 blog about the Securities and Exchange Commission’s so-called “scared-straight” campaign to clean up Wall Street. Goldstein appropriately calls the SEC’s latest round of enforcement actions, including those against Bank of America, General Electric and former American International Group CEO Hank Greenberg, “an attempt by regulators to clean-up the docket so the litigation papers can be sent to cold storage.” 

The Bank of America/SEC settlement is a perfect example of what Goldstein is talking about. Under the agreement announced Aug. 3, Bank of America would pay $33 million to settle charges by the SEC that it lied to shareholders about billions of dollars in bonuses promised to Merrill Lynch executives. Judge Jed Rakoff, the federal judge overseeing the case, has now nixed that deal, and on Monday, got BofA’s lawyer to reveal that in agreeing to the SEC’s settlement it didn’t believe it did anything wrong by deceiving shareholders. 

And therein lies the problem – and a very basic flaw in how the SEC operates. By allowing entities like Bank of America and others to simply pay a fine for an alleged offense without also publicly admitting their wrong doing, accountability becomes non-existent. The message is sent loud and clear that actions really don’t have consequences when it comes to Wall Street, and bad behavior, fraud and the like can continue on in full force.

The SEC and its new chairman, Mary Schapiro, purport to have a renewed sense of urgency for righting the wrongs of Wall Street. If that is the case, then the regulator needs to get serious about accountability. That means issuing a new mandate, one that requires individuals to admit liability before the SEC will sign off on any civil enforcement action. If the individuals in question refuse to admit their alleged offenses, then the SEC needs to put tough talk into action and proceed with legal recourse.

A federal judge is saying “no” to the $33 million settlement between Bank of America (BofA) and the Securities and Exchange Commission (SEC), refusing to sign off on the agreement and demanding answers as to why the regulator accepted what he calls a “small penalty.” Judge Jed S. Rakoff of the U.S. District Court for the Southern District of New York made his remarks at an Aug. 10 hearing, where he also asked Bank of America for the names of the executives allegedly involved in lying to investors about plans to pay billions of dollars in bonuses at Merrill Lynch, which BofA acquired during the height of the financial crisis.

“If Bank of America misled the shareholders, as you assert about a multibillion dollar matter, isn’t there something strangely askew in a fine of $33 million?” Rakoff asked the SEC’s lawyers during the Aug. 10 hearing. “It is very difficult for me to see how the proposed settlement is remotely reasonable.”

Without Judge Rakoff’s consent, the BofA/SEC settlement cannot move forward. As it stands, the judge has asked for further filings and information by Aug. 24, and says a settlement wouldn’t be approved before Sept. 9. 

On Aug. 3, Bank of America, without admitting or denying the SEC’s allegations, agreed to pay $33 million to settle charges that it misled investors about Merrill Lynch’s plans to pay executive bonuses as it prepared to report fourth-quarter losses totaling more than $15 billion. In turn, those losses affected the fiscal health of Bank of America, which acquired Merrill Lynch in January 2009.

The SEC alleges that Bank of America promised shareholders that Merrill Lynch would not pay year-end bonuses and incentives without first getting BofA’s consent. In reality, however, the SEC says the bank already had given that approval, authorizing Merrill Lynch to pay nearly $6 billion in extra compensation. 

As reported Aug. 10 by the Washington Post, Judge Rakoff had harsh words for BofA lawyers during the hearing, demanding to know the names of the individual or individuals who decided what to reveal to shareholders in a November proxy statement. According to the article, the judge specifically asked whether Bank of America chief executive Kenneth D. Lewis and former Merrill Lynch chief executive John Thain were involved.

“Was it some sort of ghost?” Rakoff asked. “Who were the people? . . . If you are correct that this proxy statement was materially misleading, then at a minimum Mr. Thain and Mr. Lewis would seem to be responsible for that, yes?”