Huge financial losses in a group of troubled Morgan Keegan & Co. bond funds affected thousands of investors, including former Chicago Bulls NBA star Horace Grant. In 2009, arbitrators awarded Grant $1.46 million for his losses in the funds. Since then, however, he’s been waging an ongoing court battle to thwart Morgan Keegan’s attempts to overturn the ruling.

Grant and other former Morgan Keegan clients contend the firm owes them millions of dollars after a group of its bond funds suffered massive losses in 2007 and 2008. The brokerage has faced more than 1,000 investor arbitration cases, as well as paid a $200 million civil regulatory fine.

As reported Oct. 15 by the Chicago Tribune, Morgan Keegan is fighting to overturn some of these awards to investors, including Grant’s. Other cases are still in the process of arbitration.

Investors and their lawyers say Morgan Keegan promoted the group of bond funds as safe, even though they had invested in highly risky mortgage-backed securities. The funds ultimately lost as much as 80% of their value following the implosion of the housing market.

Regulators have since alleged that one-time Morgan Keegan fund manager James Kelsoe deliberately inflated the value of the securities. Kelsoe later agreed to pay $500,000 in penalties and be barred from the securities industry by the Securities and Exchange Commission (SEC).

A decision in the Grant case is likely months away. Meanwhile, the former NBA player remains puzzled as to why he must continue to fight a legal battle after Morgan Keegan has paid a fine to regulators over the funds in question and one of its star fund advisers – Kelsoe – was barred from the industry altogether.

Grant noted in the Chicago Tribune article that he has been able to cash in other investments to pay his living expenses, but that other Morgan Keegan customers might not be so fortunate.

“Someone 65 or 70 years old has to go back to work because of Morgan Keegan,” Grant said in the story.

 

Closed-end bond funds saw some significant losses last week, shining the spotlight once again on the issue of “valuation” and investors’ understanding of the concept.

Just one week ago, shares of many high-yielding closed-ends were trading far above net asset value, or what their underlying assets are worth. Some funds were priced at 20% to 30% above NAV, according to an Oct. 6 article by Barron’s. One fund – Pimco High Income Fund (PHK) – was trading at a 70% premium to NAV.

Last week, Pimco’s $1.5 billion High Income Fund dropped 12.1%.

“These funds are an expensive bet on vehicles that historically have sold near net asset value. The current distortion relates to the hunger for yield at a time when 10-year Treasuries yield a pathetic 1.7%,” writes Barron’s Jacqueline Doherty.

Sixty-six percent of taxable bond funds and 73% of municipal-bond funds trade above NAV now, versus roughly 30% a year ago and in 2006, before the financial crisis, according to Thomas J. Herzfeld Advisors, a closed-end specialist in Miami Beach.

Closed-end bond funds are mainly bought and sold by retail investors. Strong demand for the funds has pushed their share prices higher than the net asset value of the underlying assets. To generate impressive distributions, many closed-end funds turn to using leverage. If interest rates rise, however, or the economy falters, the funds’ investments can quickly deteriorate in value.

More than leverage, some closed-end funds use options and short-selling to enhance their returns. For example, Gabelli Utility relies on auction-rate securities for leverage; Pimco Strategic Global Government Fund (RCS) uses reverse repurchase agreements, and Cushing MLP Total Return Fund (SRV) uses a margin account.

As reported in the Barron’s article, leverage may have enhanced these funds’ returns since the markets bottomed, but it will amplify any losses if the markets turn down.

 

 

State regulators are calling on the Securities and Exchange Commission (SEC) to start over on a proposed rule to authorize advertising for private placements.

Two months ago, the SEC put forth the proposed rule on private-placement advertising as part of regulations to implement the JOBS Act. Supporters of the bill contend it is designed to ease financial regulations on start-up companies, as well as help spur economic growth. Critics, however, say the SEC’s proposed rule is too vague and ultimately would be a disservice to investors.

“Lifting the advertising ban on these highly risky, illiquid offerings without requiring appropriate safeguards will create chaos in the market and expose investors to an even greater risk of fraud and abuse,” said Heath Abshure, Arkansas’ securities commissioner and president of the North American Securities Administrators Association (NASAA), in an Oct. 9 story by Investment News.

According to Barbara Roper, director of investor protection at the Consumer Federation of America, the SEC is rushing to advance the proposal in order to meet a congressional deadline.

Meanwhile, NASAA wants the SEC to redo the rule to ensure that an investor is accredited before purchasing shares in a private placement. It also wants to require the filing of Form D before ads are launched.

State securities regulators had harsh words for the Securities and Exchange Commission (SEC) earlier this week over a proposal that would end advertising restrictions on private placements.

Private placements have been at the center of scrutiny by regulators following the debacle involving Medical Capital Securities and Provident Royalties. Both entities were charged with securities fraud by the SEC in July 2009. Both deals, which the SEC has called Ponzi schemes, cost investors dearly: $1 billion in the case of Medical Capital and more than $485 million for Provident Royalties.

The SEC’s new proposal would essentially open the door to general solicitation for private securities issued under Rule 506 of SEC Regulation D. The change is mandated under the Jump-start Our Business Startups Act.

“Overall, we are greatly disappointed in the proposed amendment to Rule 506,” the North American Securities Administrators Association stated in a comment letter, according to an Oct. 3 article by Investment News.

“It fails to give sufficient guidance to issuers, even though that type of guidance is mandated by the JOBS Act, and it fails to implement any protections for investors, even those that would be minimally burdensome to issuers,” the NASAA letter went on to read. “In short, the commission has neglected its duty to both issuers and investors.”

Rule 506 is considered a “safe harbor” for the private offering exemption of Section 4(2) of the Securities Act. Companies using Rule 506 exemption can raise an unlimited amount of money from accredited investors. Currently, the rules do not allow general solicitation or advertising of private offerings. 

State regulators argue that without the advertising prohibition, additional investor protections are needed, such as stricter verification mechanisms to ensure only accredited investors buy private deals.

 

As investors search for better yields with their investments and firms look for innovative financial products to meet that demand, the potential for sales practices abuses also becomes bigger than ever. Richard Ketchum, Chairman and CEO of the Financial Industry Regulatory Authority (FINRA), recently offered comments on this topic at the Securities Industry and Financial Markets Association’s Complex Products Forum in New York.

In his remarks, Ketchum drew attention to today’s growing array of new and complicated investment products and the importance of customer suitability, financial advisor and investor education, due diligence, and the role they play in the sale of complex products to retail investors.

Among other things, Ketchum said broker/dealer firms that offer products such as private placements, structured notes, non-traded real estate investment trusts (REITs) and inverse and leveraged exchange-traded funds (ETFs) must step up their efforts to supervise sellers at every stage of the investment process.

“In the words of the great American philosopher, Casey Stengel: “Most ball games are lost, not won,” Ketchum said. “A baseball game is more likely lost through unforced errors, poor judgment and boneheaded play. Often, the team’s management will properly be held accountable. As we have seen in recent years, a firm that becomes unduly aggressive about the products it sells will forfeit its reputation, its customers and, ultimately, its market share.”

Ketchum noted the need for continuing education for financial advisers who sell complex investments to make sure they are qualified to do so. He also advised firms to more closely review any special incentives provided to their advisers and whether those incentives influence their recommendations or selling methods.

Ketchum concluded his remarks by calling for a heightened awareness on the part of advisors to ensure customers who purchase complex products understand their basic features.

“Some firms only permit the sale of these products to customers who are qualified to trade options,” Ketchum said. “The sale of complex products through discretionary accounts is a particular issue. As we have repeatedly stated, financial advisers should discuss the basic features of these products with retail customers, and include in the discussion the potential risks of those products under different market scenarios. Other additional steps might be needed to ensure that the recommendation of the structured note is consistent with the investment objectives and risk tolerance of particular customers.”

Non-traded real estate investment trusts (REITs) and the ways in which broker/dealers market and sell them to investors are facing increased scrutiny by the Financial Industry Regulatory Authority (FINRA).

FINRA has issued several Investor Alerts on non-traded REITs over the past two years, with examiners ramping up efforts to investigate the sales practices of sellers of the products. As reported Oct. 1 by Investment News, FINRA found shoddy due diligence at several firms in those investigations, as well as a failure of some to heed the red flags that existed prior to selling the products to investors.

Non-traded REITs were the focus of a speech made Sept. 27 by Susan F. Axelrod, FINRA’s Executive Vice President, Member Regulation Sales Practice, for the Securities Industry and Financial Markets Association’s Complex Products Forum. In her comments, Axelrod stated that investigations by FINRA examiners found many non-traded REIT investors to be confused about the features, fees and liquidity of non-traded REITs, as well as the distribution structure and the fact that there’s no guarantee distributions will continue in the same amount or at all.

Axelrod also noted that some firms failed to conduct adequate training for brokers who sell non-traded REITs. In other instances, Axelrod says FINRA examiners uncovered misrepresentations of the product’s features, including information on distributions and share values, in the advertising, sales literature and correspondence between brokers and investors.

Facebook and its underwriters have a new problem on their hands: They’ve been hit with approximately 50 arbitration claims and civil lawsuits from investors following Facebook’s initial public offering in May.

And there’s other players mired in Facebook’s legal issues. As reported Sept. 26 by the Wall Street Journal, hundreds of brokers and financial firms that pushed investors to buy Facebook shares also could potentially face arbitration claims and lawsuits.

According to the WSJ article, the majority of investors are taking legal action against Facebook and its main underwriter, Morgan Stanley, for failing to adequately warn them how mobile usage could negatively impact the company’s financials.

Steven Caruso, a partner at law firm Maddox Hargett & Caruso in New York, said in the Wall Street Journal article that he is preparing to file as many as a dozen arbitration claims with the Financial Industry Regulatory Authority (FINRA) on behalf of investors who claim the deal’s price was “elevated” or they “weren’t given the same information.”

Facebook’s IPO on May 18 was one of the most anticipated events of 2012. The much-heralded IPO has since been on downhill slide, however. The initial IPO share price of $38 has fallen 47% and erased about $38 billion in Facebook’s stock-market value. On Wednesday, Sept. 26, the company’s shares were listed at $19.94 in New York Stock Exchange trading.

The Securities and Exchange Commission (SEC) is seeking a court emergency order to freeze the assets of the Atlanta-based investment advisory firm Summit Wealth Management and its principal, Angelo Alleca, for running a Ponzi-like scheme that cost investors some $17 million.

The SEC says Alleca defrauded investors in what it describes as a purported fund-of-funds strategy that tried to hide trading losses by creating new private funds to make money to pay back the original fund investors.

“Alleca told Summit Wealth clients that he was investing their money in funds, but instead he was rolling the dice in the stock market without success,” said Bruce Karpati, Chief of the SEC Enforcement Division’s Asset Management Unit.  “Rather than fess up about his trading losses, Alleca tried a cover up by creating new funds. Instead of winning back the money, he just compounded his fraud by suffering further losses.”

According to the SEC’s complaint filed Sept. 19 in an Atlantafederal court, Alleca and Summit Wealth Management offered and sold interests in Summit Fund, which they told clients was operating as a fund-of-funds. Clients thought Alleca andSummitwere investing their money in other funds and investment products rather than directly in stocks and other securities. The fund-of-funds investment strategy is intended to diversify investor money and minimize exposure to risks.

Instead of engaging in active securities trading with his clients’ money, however, Alleca incurred substantial losses. He subsequently concealed the Summit Fund trading losses from investors and provided them with false account statements, the SEC says.

When it came time to meet redemption requests from Summit Fund investors, the SEC alleges that Alleca created at least two hedge funds to raise money from Summit Wealth clients – the Private Credit Opportunities Fund LLC and Asset Class Diversification Fund LP. Alleca’s plan was to cover up the losses that he had incurred in Summit Fund by illegally transferring profits from the new funds in a Ponzi-like fashion in order to meet earlier redemption requests.

Alleca’s plan backfired when those successive funds incurred further trading losses. Meanwhile, Alleca continued to issue false account statements to investors in Summit Fund, as well as the additional funds in order to hide the actual losses on their investments.

Investors, especially elderly investors, want and desperately need more information regarding financial professionals and investment products and services, says a new report from the Securities and Exchange Commission (SEC). The report also shows that investors lack critical knowledge of ways to avoid investment fraud.

Results of the study – which was conducted by the SEC and mandated by the Dodd-Frank Wall Street Reform Act and Consumer Protection Act – revealed in-depth findings about investors’ understanding of their investments.

“Studies have found that investors do not understand the most elementary financial concepts, such as compound interest and inflation. Studies have also found that many investors do not understand other key financial concepts, such as diversification or the differences between stocks and bonds, and are not fully aware of investment costs and their impact on investment returns. Moreover, based on studies cited in the Library of Congress Report, investors lack critical knowledge about investment fraud,” stated one passage in the 182-page report.

Among the key findings of the study:

• Fees, investment performance and disciplinary history are top priorities for investors when choosing an investment advisor.
• Investors want a plain language description of the investment product being offered.
• A narrative explanation of advisor fees and compensation and a fee table would be useful to investors.
• The majority of regular investors surveyed found prospectuses highlighted important information and were well organized, but only around half of them thought they were user-friendly or written in clear, concise language that they could understand.
• Approximately 31.8% of the survey respondents indicated they understand the term, annual asset fees, while about 46.2% of respondents indicated they thought they knew what the term means. When asked to determine which mutual funds provided the greatest and least financial incentive to sell their shares, less than one-seventh of online survey respondents correctly determined that additional information would be needed to make this determination.
• Slightly more than one-half (55.1%) of online survey respondents indicated they  want to know whether the individual advising them (as opposed to the financial services firm itself) would receive some of the portion of these annual asset payments.

“What is alarming is Americans seem to believe they are far better at handling their finances than they actually are,” said FINRA Foundation President Gerri Walsh in a recent NBC News.com article. “This is particularly worrying, given that most investments Americans make are for their retirement.

“When you stack investor knowledge against what people are doing with their retirement investments you see a frightening picture emerge,” she said.

 

A New York arbitration panel of the Financial Industry Regulatory Authority (FINRA) has ordered Citigroup Global Markets, Inc. to pay compensatory damages of more than $1.4 million to an investor who suffered losses tied to a municipal bond fund that was marketed as safe and secure but in reality contained risky derivative securities.

The investor purchased Citi’s Rochester Municipal Fund in 2007 after Citigroup recommended it as a safe alternative to her municipal bond fund investments and one that would pay slightly more interest. Instead, the Rochester Municipal Fund consisted mainly of toxic and speculative derivative securities whose value is dependent on the performance of underlying assets.

“Through the issuance of this arbitration award, our client not only received a substantial portion of the losses that she sustained as a result of her investment in the Rochester Municipal Fund, but the arbitrators also further held Citigroup liable for 9% of statutory interest on her principal loss, as well,” says Maddox Hargett & Caruso’s Steven B. Caruso, who served as counsel for the investor.

The case shines an important spotlight on the questionable sales practices of brokers and the impact those practices can have on investors regardless of their wealth or financial sophistication.

“Wealthy investors in particular are often asked to defend their investment choices by brokerage lawyers in arbitration cases, because of the false assumption that they must have a deeper understanding of what they are buying than average investors, said Caruso in a Sept. 12 article by Reuters. “Wall Street often mistakenly equates wealth with financial know-how.”

In addition to this FINRA arbitration award, Maddox Hargett & Caruso, P.C. has served as co-counsel in numerous other FINRA arbitration proceedings involving Citigroup’s ASTA-MAT municipal arbitrage products. To date, investors in those cases have been awarded damages of more than $60 million.