Investors, mauled by bear market, come clawing after their brokers

Miriam Hill INQUIRER STAFF WRITER

Now for the finger-pointing.

Investors, faced with major losses on their stock portfolios, are now going after their brokers, saying they got bad advice that decimated their savings.

More than 6,700 investors are expected to file claims against their brokers this year. That would be a 21 percent increase over 2000, according to National Association of Securities Dealers Dispute Resolution, the industry-run organization that oversees most claims against brokers. Last year, investors won $55 million total in arbitration claims, and money was awarded in 53 percent of the cases.

Many of the cases involve brokers who invested big chunks of their clients' portfolios in high-flying technology companies such as Cisco Systems Inc. and EBay Inc., only to see those holdings tank along with the tech sector. Claims involving margin loans - a high-risk strategy in which an investor borrows money to buy stocks - are also rising.

The increase in claims is the natural fallout from a bull market fueled by unrealistic expectations and by greed and ignorance on the part of brokerage firms, the media and individual investors, experts said.

"The bull market masked a number of sins," said Brad Skolnik, Indiana securities commissioner and former head of the North American Securities Administrators Association, a group of state regulators. "Many investors have learned that many of the investments they were in were not really suitable for them. Many of the investors were relative novices who were not adequately advised that a portfolio should be well diversified."

One such novice was Primo Del Grande of Ridley Park.

Del Grande, a 45-year-old hairdresser with a high school education, wanted to create a nest egg out of a $135,000 settlement following a car accident that left him out of work for nine months. An acquaintance recommended a broker at UBS/PaineWebber Inc. in Philadelphia.

Del Grande said he told PaineWebber he had never invested before, outside of some mutual funds in a 401(k) retirement plan.

The broker no longer works at the firm and could not be located for comment. PaineWebber, would not comment.

Records kept by the NASD on all brokers show that in almost two years in the industry, no other complaints were filed against him.

Records show that most of Del Grande's money was invested in such volatile tech stocks as Ciena Corp. and Juniper Networks Inc., both of which make telecommunications equipment.

PaineWebber also had Del Grande borrow against his account through a margin loan that totaled $219,000 - almost 80 percent of the value of the entire account - at its highest point last October, according to statements from PaineWebber.

In an arbitration claim filed last month with the New York Stock Exchange, Del Grande alleges that the trades were made without his permission. He also said he did not realize he had signed an agreement allowing the margin debt. The complaint also accuses PaineWebber of trading too much, or churning, the account.

What Del Grande does recall is the constant flurry of paperwork, the new and arcane language of the investment world.

"People will say I should have known better, but if I had known better, I wouldn't have come [to PaineWebber] in the first place," Del Grande said. He said that he told the broker he did not understand the statements he was receiving from PaineWebber, but that the broker told him not to worry.

His losses mounted he lost more than $12,000 on Ciena alone, according to his year-end 2000 statement from PaineWebber - and they were aggravated by mounting margin debt.

Margin is one of the riskiest investing strategies. It involves borrowing money from the brokerage firm to buy stocks. If the value of the stock rises, it magnifies the gains. But margin works the same way on the downside, magnifying losses.

Let's say an investor buys $6,000 of a stock, using his own money. If the stock drops 30 percent, the investor loses $1,800.

Now consider an investor who buys $10,000 in stock, using $6,000 of his own money and borrowing $4,000 on margin. This time, when the stock falls 30 percent, the investor loses $3,000 - $1,800 of his own money, plus $1,200 that he must repay the broker on the margin loan. So instead of losing just 30 percent, the investor loses 50 percent, or $3,000 of his original $6,000 investment.

Some investors end up losing even more than they borrow, and many are unaware that their broker can sell securities in a margin account without notifying them, to maintain the proper level of collateral. This is known as a margin call, when brokers sell the securities after the price of the stock, which serves as collateral, drops.

Brokers, however, have an interest in promoting margin because it brings in revenue for them and for their firms. Del Grande, for example, paid $2,620 in margin interest over seven months.

Today, Del Grande has about $5,000 of his original money left.

"It's been pretty much of a nightmare," he said.

Del Grande's lawyer, Debra Speyer, a Center City lawyer who represents investors, said the mix of technology stocks and heavy margin debt was clearly inappropriate.

Del Grande had listed his risk tolerance as moderate on account statements.

Speyer said many of the cases she was seeing involved young, relatively inexperienced brokers who might not have understood the risks they were creating for their clients. The bull market of the 1990s pushed the number of brokers up 86 percent, to 775,000, during the decade, according to the Securities Industry Association. Many of these brokers had probably never lived through a bear market, Speyer said. Brokerage firms must supervise all brokers' activity, but some may have looked the other way because huge sums of money were involved.

"These firms were making millions and millions of dollars," Speyer said. "I don't necessarily blame the stock brokers for pushing these stocks. They were told by their firms to push these stocks. You have to look at the entire industry, and not just the brokers."

The pressure was pervasive. On television, financial news shows in the late 1990s were reporting astounding gains on stocks by the minute. Some clients pushed their brokers to deliver the big profits they were hearing about. Some brokers undoubtedly saved customers from bad decisions.

"To be fair, brokers faced a lot of pressure because they would hear clients say, 'Why am I not in AOL, why am I not in Cisco, why am I not in EBay?' The really competent broker would say, 'Because it will go down as fast as it goes up,' " said James Eccleston, a Chicago lawyer who handles investor claims against brokers.

Lawyers for investors and brokers agree that many complaints arise because investors don't understand what they are signing. Brokers often fill out new-account forms based on an interview with the client over the phone. Then, when problems occur, clients are sometimes surprised to find that their account forms list them as a "speculative" or "aggressive" investor.

Many investors also assume their broker knows what he or she is doing.

Richard Justice, who lives in the suburbs of Chicago, said he invested heavily in the technology sector because his broker at Edward D. Jones & Co. said technology companies were unstoppable.

"I took his advice and fell on my face," said Justice, who said he lost about $40,000.

Edward Jones declined comment.

Understanding the risks of margin can be another problem. Donna and Emil Maternia of Gladwyne say they lost $56,000, about half of their original investment, in part because their broker at First Union Securities put them on margin in technology stocks without their knowledge. On the account form they signed, they had to check a box if they did not want to use margin. Not understanding the importance of the box, they did not check it.

"I swear I never heard of margin," Emil Maternia, 42, said. First Union spokesman Tony Materra said he could not comment on the case. The Maternias' broker left First Union in April.

Bruce Lewitas, who is handling the claim for First Union, would not comment on the case. In his written response to the claim, however, Lewitas argues that the investments were suitable because the Maternias were experienced investors. Lewitas' response also says that Emil Maternia directed his broker to trade frequently and that the couple knew about the margin account.

The Maternias deny those assertions. The case is headed for arbitration.

It is clear that margin caused problems for many investors. Margin debt hit a high of $299 billion in March of last year. As those figures grew, so did investor complaints.

Margin calls accounted for just 35 arbitration cases in 1997, according to the NASD. That number soared to 284 in all of 2000 and 209 in the first six months of this year.

In April the NASD and the Securities and Exchange Commission issued new guidelines requiring brokers to better disclose the risks of margin. Among the requirements: that customers be told in writing that margin can cause them to lose more than the value of their accounts and that their broker can sell their securities without their permission to meet a margin call.

Many people hire a broker because they want someone else to make financial decisions for them, but investors must educate themselves even if they hire a professional, said Susan Wyderko, director of the Office of Investor Education at the SEC.

She recommends that clients interview potential brokers and ask such questions as: "What are your investment objectives?" and "How much experience have you had with customers such as me?" Investors also should read brokerage statements regularly and make sure they understand them.

"We believe strongly here that an educated investor is absolutely the best defense against all kinds of problems," she said.