How to shield portfolios from broker abuse
New York — ``Conservative investments only,'' is what Eugene and Julia McMahon say they told their broker. But in two years they lost $350,000. Now, the McMahons are trying to charge Shearson Lehman Brothers with ``churning'' - that is, excessive trading to generate commissions - as well as with misrepresentation and other charges. The Supreme Court is considering the case (story, Page 22).
Broker-client disputes not uncommon. In fact, they're rising in step with the bull market. Last year, the Securities and Exchange Commission received 25,000 complaints against brokers, up from 18,500 in 1983.
The figures do not indicate a surge in dishonest brokers as much as poor communication, securities lawyers say. And many disputes could be avoided if both customers and brokers considered the new account paper work as something more than bureaucratic red tape.
Typically, the process starts with brokers quizzing clients in order to fill out a worksheet. The broker's responsibility, mandated by industry rules, is ``to know the customer.'' The customer, in turn, must be willing to give accurate information about his or her finances and investment goals. It's a crucial exchange.
``A lot of basic principles flow from this information,'' says Earl K. Cantwell, a partner at Jaeckle, Fleischmann & Mugel, a law firm in Buffalo, N.Y. Mr. Cantwell is co-author of an article on customers' rights in the March issue of the Chicago-based American Association of Individual Investors Journal.
``It's very important to discuss thoroughly your income, net worth, and especially your investment objectives.'' A client should be honest and as specific as possible, he advises. The broker will devise strategy and execute trades based on this data.
One of the most common complaints against brokers is taking excessive risks. If a client simply denotes ``income'' as an investment goal, the broker can read that as either high-yielding junk bonds or United States government bonds - two very different securities.
``Feel free to write exactly what you want on the form or in a letter: `I want only investment-grade securities,''' he says. ``Or what you don't want: `No speculative stocks.'''
Once the financial profile form is completed, a customer should review and sign it. Often customers fail to check the accuracy of the broker's notes. As the market, tax laws, or personal financial conditions change, a client and broker may agree on a new strategy over the phone. But changes should be spelled out as soon as possible, Cantwell says.
The McMahons apparently signed the routine four-page agreement in a dimly lit restaurant. In that contract lies a clause, standard throughout the industry, which requires customers to settle disputes through arbitration, not the courts.
For small accounts, say under $50,000, most legal experts advise signing a contract with an arbitration clause. The time and costs involved in litigation over a small sum make arbitration preferable.
But the McMahons opened their account with $500,000 in savings and employee pension money. Under such circumstances, ``I would want to retain my right to judicial litigation,'' says G.Richard Shell of the Wharton School at the University of Pennsylvania.
To retain that right, an investor must cross out the arbitration clause and initial it. ``Don't be intimidated,'' says Cantwell.
``How agreeable the broker is to changes depends on the amount of money you're bringing to the firm. Smaller firms may be more accommodating,'' observes Theodore G. Eppenstein, of Eppenstein & Eppenstein, the New York law firm representing the McMahons.
Cantwell says if the brokerage house will not go along, ``take your business elsewhere.''
If one does accept arbitration, one does not have to accept the forum stipulated in the contract. Often, the New York Stock Exchange, American Stock Exchange, or National Association of Securities Dealers is listed as the arbitrator. If one does not live near New York, arbitrating through the exchanges may be inconvenient.
Also, the exchanges often appoint the panel of arbitrators with little say from the disgruntled customer. Some critics question the impartiality of these panels, since they are often composed of people with business ties to the securities industry.
To select another arbitration group, a customer may simply write it in the contract; for instance, the American Arbitration Association, based in New York, which is the largest independent arbitration organization.
``I would prefer the AAA because it allows parties a greater role in picking their arbitrators,'' says Mr. Shell at Wharton. The fees of this association are somewhat higher than those of the exchange, but the organization has 60,000 local arbitrators around the country, so claimants can forgo a trip to New York.
Finally, to avoid misunderstandings, a customer should not give a broker free rein over trading. The McMahons opened a ``discretionary'' account, which authorizes the broker to buy and sell securities without first checking with the customer. ``Discretion is like giving the broker a pen to write a paycheck,'' says Mr. Eppenstein, the McMahons' attorney.
Investors occasionally open temporary discretion accounts if they are away on vacation. But ``avoid them unless absolutely necessary and revoke them as soon as possible,'' advises Jay J. Pack, a partner a Silberger, Rosenthal & Co., and author of ``How to Talk to a Broker'' (Barnes & Noble Books, $5.95).