Detecting Improper Portfolio Management Activity

By Seth C. Anderson and Lynn Comer Jones

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Ineptitude in management is difficult to determine. Misappropriation of assets, although easy to quantify, is beyond the scope of this article. The authors will endeavor to provide an efficient overview of suitability and churning. According to S.C. Anderson and D.A. Winslow [“Definining Suitability,” Kentucky Law Journal, 81, no. 1 (1992)], suitability violations involve the use of investment vehicles inappropriate to meet an investor’s objectives. Churning, according to Winslow and Anderson [“Model for Determining the Excessive Trading Element in Churning Claims,” North Carolina Law Review, 6 (January 1990)], involves the excessive trading of investment vehicles. When either or both of these activities occur, the investor’s best interests have not been served, and there has been a violation of the fiduciary duties owed to the investor by the financial professional.

Investment Professionals’ Duties

According to a 2004 report from the Zero Alpha Group, 26% of investors understand that the primary role of stockbrokers is merely to buy and sell investment products; the majority of investors (53%) incorrectly believe that investment advice is a key service offered by stockbrokers.

The requirement that a financial advisor recommend proper investment actions has several sources, primarily in the rules of the self-regulatory organizations (SRO). For example, the New York Stock Exchange (NYSE) requires that each member “know [the] customer” with respect to recommendations, sales, or offers; this directive contains an implicit duty of the financial advisor that recommendations reasonably relate to the needs revealed by the customer’s particular situation. Also, National Association of Security Dealers (NASD) Rule 2300, “Transactions with Customers,” includes Conduct Rule 2310, “Recommendations to Customers (Suitability),” which requires a financial advisor to have reasonable grounds for believing that an investment is suitable and make reasonable efforts to obtain information concerning the customer’s financial status and investment objectives, and other reasonable information before recommending a particular investment. In the 2001 NASD Securities Manual, the rule states:

(a) In recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.
(b) Prior to the execution of a transaction recommended to a non-institutional customer, other than transactions with customers where investments are limited to money market mutual funds, a member shall make reasonable efforts to obtain information concerning:

(1) the customer’s financial status;
(2) the customer’s tax status;
(3) the customer’s investment objectives; and
(4) such other information used or considered to be reasonable by such member or registered representative in making recommendations to the customer.

Rule 2300 also addresses the important issues of excessive trading and trading in mutual fund shares. The NASD Online Manual (nasd.complinet.com/nasd/display/index.html) specifically prohibits trading in mutual fund shares because “these securities are not proper trading vehicles.” Although the manual gives no specific numerical guidelines for determining the overtrading of stocks, the commonly argued guidelines below have been used in court cases and arbitrations.

If a financial advisor violates any of the aforementioned rules, the SRO may institute a disciplinary action, although these have been infrequent. If the financial advisor’s actions violate Rule 10b-5 [the general securities antifraud rule promulgated under section 10(b) of the Securities Exchange Act of 1934] or common-law fiduciary duties, the investor has a potential private right of action that might result in an award of damages against the financial advisor. It is worth noting that, according to J.S. Cohen and M.B. Lee (“Arbitration Showdown: The Battles Over Account Decisions Gone Wrong Are Heating Up,” Financial Planning, July 2003), the number of filed suitability arbitration claims increased 22% from 2002 to 2003.

Elements of a Violation

According to Anderson and Winslow (1992), for an advisor to violate the fiduciary duty owed to a customer insofar as suitability or churning are concerned, specific elements must be present: 1) explicit or implicit control over the account by the advisor; 2) excessive trading; and 3) scienter, meaning reckless disregard for the investor’s welfare. These elements are often readily determinable but also usually involve legal issues beyond this article.

Risk Aversion and Investor Objectives

The concept of risk aversion is fundamental to modern finance theory. It holds that a rational investor will assume incremental risks only if incremental returns can be expected. The risk-return paradigm can be used to show that particular types of investments are suitable for certain investor objectives.

Exhibit 1 (adapted from Anderson and Winslow, 1992) presents the relative positions of a variety of investment vehicles within a risk-return space. Government securities are the least risky investment. Savings accounts are considered less risky than corporate bonds, which in turn are less risky than preferred stock. Futures and options can be viewed as the riskiest financial assets.

Ultimately, an investment vehicle’s risk-return characteristics determine its suitability for an investor with a given objective. Fortunately, data are available that show the historical risk-return relationship for the broad classes of financial instruments comprising the vast majority of investment vehicles. Exhibit 2 [from R.G. Ibbotson and R.A. Sinquefield, Stocks, Bonds, Bills, and Inflation: Historical Returns (1926–2004), Dow Jones-Irwin, 2004] shows the arithmetic mean return for five groups of investment vehicles for the period 1926 to 2003.

The standard deviation of each series is listed for comparison of the relative riskiness of each group. Common stocks have exhibited greater riskiness than bonds, as measured by the standard deviation of returns. Small company stocks have returned more than common stocks in the aggregate, and their standard deviation of returns has been greater.

Exhibit 2 also shows that the relative positions of the investment vehicles are approximate. Mutual funds may be stock- or bond-oriented, and may be specialized or general. A fund’s objectives will determine where it lies in risk-return space relative to other funds. The particular use of a financial vehicle may also determine where a fund lies. For example, put options may be used for pure speculation, or they may be used more conservatively for protection against price declines.

Although the relative positions of different vehicles are approximate, certain vehicles are more appropriate for specific classes of investors. Exhibit 3 presents a stereotypical view of where particular classes of investors lie in risk-return space.

High-risk investing as a rule should be reserved for sophisticated investors that are willing and able to lose money in anticipation of gaining large returns. At the other end of the spectrum lie investors such as retirees, whose primary objective is often preservation of capital rather than large returns.

Investor Attributes

Determining where a particular investor lies in the risk-return space of Exhibit 3 is ultimately a function of three interrelated attributes: investment horizon, financial resiliency, and relative risk aversion.

Investment horizon. An investor with a long investment horizon can take greater risks because there is more time to recover from potential losses. For example, in recent years technology issues have been detrimental to young professionals’ portfolios, but disastrous to the portfolios of retirees.

Financial resiliency. The retiree with a $2 million portfolio can obviously better withstand a $200,000 loss than can one with a $700,000 portfolio. For young investors, however, the impact of their time horizon may override the obvious effect of losses relative to portfolio worth. If two young professionals, Jones and Smith, with similar retirement goals have initial portfolios of $5,000 and $50,000, respectively, then Jones may justifiably invest in securities that are more risky than Smith because Jones seeks higher returns.

Relative risk aversion. Even if two investors are identical in time horizon and in portfolio worth, they may differ widely in risk tolerance. Some individuals have a much lower tolerance for risk-taking than others, and this should be taken into consideration when considering the suitability of particular investments.

Broker Tax-Reporting Requirements

Brokers are required to provide an information return, Form 1099-B, Proceeds From Broker and Barter Exchange Transactions, to their investors by January 31 [IRC section 6045(b); Treasury Regulations section 1.6045-1(k)(2)]. Brokers must report each sale transaction on a separate Form 1099-B [Treasury Regulations section 1.6045-1(c)(2)], except for regulated futures and foreign currency transactions, which may be reported in the aggregate [Treasury Regulations section 1.6045-1(c)(5)].

Recognizing Suspect Broker Transactions

Matching an investor’s sale transactions between the 1099-B and the brokerage account statement facilitates the identification of suspect transactions, which may involve any of the following: mutual fund sales; unusual trading activity; large commissions; low-priced stocks; options activity; and investor suitability issues such as age, wealth, and risk tolerance.

Mutual fund sales. Mutual funds are long-term investment vehicles and may be either front-end, level, or rear-end load funds on which investors pay commissions, respectively, when purchased, over time, or upon sale. Transactions more frequent than annually are usually suspect.

Unusual trading activity. Annualized trading activity (gross purchases plus sales, divided by two) relative to average account balances should not be greater than one. The ultimate impact of a turnover greater than one is commission expense, which amounts to approximately 4% annually of an average account balance (see Winslow and Anderson, 1990). This 4% must be considered in light of the fact that, historically, stock returns have been in the 10% to 12% range. Because bond returns have been in the 6% to 8% range, annual expenses for bond portfolios should not exceed 2%.

Low-priced stocks. Active trading in low-priced stocks (under $10 per share) is frequently encountered in churning claims. Trading in these securities often allows for excessive commission charges, which are sometimes hidden in net trades of unlisted securities. In recent years many brokerage firms have begun discouraging broker solicitations of stocks under $5 per share; thus, trading activity in such issues is suspect.

Options. Option trading is highly speculative and usually generates large commissions. A form of nonspeculative option trading is the writing of covered calls in order to generate income. Option speculation should be used only by speculators able to lose capital in the pursuit of risky profits.

Investor-Specific Issues

Other potential problem areas are specific to particular investors rather than the broader issues discussed above. For example, elderly investors seeking high income may be sold restricted or otherwise unsuitable issues that pay large, risky returns but have potential liquidity problems if the investor needs to cash out. Advisors should be especially wary of voluminous trading activity when investors are at or near retirement age because, as noted, trading usually decreases investment returns. Another possible misuse of investment tactics involves margin trading, by which borrowed funds lever an account into an unnecessarily risky position. With margin positions, the combined impact of commissions and margin interest expense frequently outweigh expected returns.

A brokerage account statement should disclose the sale quantity, sale price, and net proceeds of each sale as seen in the following example. John C. Smith is a 76-year-old, risk-averse retiree who relies partially on dividend income for basic living expenses. Smith’s brokerage account statement (Exhibit 4) lists multiple sales transactions for 2004. The issue of overtrading initially seems probable because of the large number of sales relative to the year-end number of holdings. In addition, the sales represent approximately 190% of the total portfolio year-end value, for an approximate turnover ratio of 1.9. Assuming that comparable quantities of purchases were made, then the annual expense ratio is approximately 8%; $11,600 in commissions relative to an ending portfolio value of $152,679.50. The sale transactions may also be suspect from a suitability perspective because many of the stocks sold were higher dividend–paying stocks (ALD, CLP, EPD, ERF, RF, and SNH) than those retained in the portfolio. Under the circumstances, the holding of non–dividend paying stocks (CSCO and MSO) is suspect.

Investor’s Options When Problems Occur

The investor ultimately has three options when problems of suitability or churning are suspected. The investor can go directly to the brokerage operation, pursue mediation, or pursue arbitration. At the brokerage operation, the broker is the first point of contact, followed by the office manager, then the home-office compliance area. When dealing with the brokerage operation, investors should provide written communications that clearly define the concerns and provide specific items to which the brokerage operation can respond. If the brokerage operation does not respond satisfactorily, the NASD has a standard process for arbitration and mediation. The NASD regulates these dispute forums under rule 10000, Code of Arbitration Procedure, adopted in the 1970s. NASD Resolution, Inc., offers dispute services to public customers and NASD members.

Mediation is voluntary, less expensive than arbitration or litigation (filing fees of $50, $150, or $300, based on the amount in controversy), nonbinding (the mediator does not decide the case), and since 1995 has an 80% settlement rate. The NASD prefers that parties undergo mediation before filing an arbitration claim. Arbitration is more formal and similar to a court trial. The parties present their cases and stipulate the restitution or damages they are seeking. The arbitrators weigh the evidence and make a determination with a set award that is binding. Investors can file mediation and arbitration claims at the NASD website, www.nasd.com.