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Brokerage Watchdog Fights For Credibility

USA Today

Plenty of investors are upset with their stockbrokers, but they are also losing faith that Wall Street’s watchdog group will help them.

Consider this: Investor arbitration claims against brokers jumped 24% last year. But, at the same time, investor complaints to that watchdog group, the National Association of Securities Dealers (NASD), fell 22%.

That may soon change. Spurred by an exclusive USA TODAY review of 2,000 disciplinary actions against brokers and firms over 20 months through the end of 2001, the NASD voted Thursday to improve the way it responds to investor complaints.

“We understand that (our enforcement procedures) have created some problems for people,” says Elisse Walter, an executive vice president for the regulatory division of the NASD.

While attention has focused on the conflicts of interest surrounding Arthur Andersen and Enron and the conflicts between stock analysts and investment banking departments, little notice has been paid to the potential conflicts of interest between the NASD and the brokerage industry.

The NASD is in charge of policing Wall Street and settling disputes between brokerages and investors. All Wall Street firms and brokers must belong to the NASD and fund its $400 million annual budget.

Critics say that dependence on Wall Street funding has eroded the NASD’s credibility. Even on big cases, the association often is slow to punish its members.

“The self-regulatory organizations that are supposed to be there to protect (investors) have failed, and I’m not waiting any longer for them to act,” says Eliot Spitzer, attorney general for New York.

Spitzer is investigating biased Wall Street research. He forced Merrill Lynch to agree to a $100 million fine, apologize for misleading investors and change how it pays stock analysts. Suspecting that other Wall Street firms engage in a “quid pro quo” arrangement in which they pitch dubious stocks to gain lucrative investment-banking business, Spitzer has served subpoenas on at least five other investment banks, including Morgan Stanley and Credit Suisse First Boston.

NASD has yet to take disciplinary action against analysts or big Wall Street firms that pumped up stocks with biased ratings, but it did draft the rules to curb the conflicts of interest that the Securities and Exchange Commission just approved.

And USA TODAY’s analysis of the NASD’s disciplinary actions, as well as interviews with dozens of lawyers, investors and regulators, shows other weaknesses in the NASD’s efforts to protect investors:

  • The NASD closes most of its investigations into customer complaints with a “no-action” letter. Plaintiff attorneys know these letters as the “kiss of death,” because they can hurt the investor’s arbitration case.
  • If NASD arbitration panels, which preside over hundreds of cases a year, determine misconduct on the part of a broker, they seldom report even the worst behavior back to the NASD for enforcement action against the broker.
  • Investors who want to check a broker’s record are usually better off going to their state securities regulators than the NASD.

Mary Schapiro, president of the NASD’s regulatory division and a former SEC commissioner, ardently defends self-regulation. “It works in the securities industry. Does it work perfectly? No. Does anything work perfectly? No.” And she insists, “We stay on the path of market integrity and investor protection in virtually everything we do. That’s what drives us.”

Thursday, the NASD’s board of directors voted to change the wording of the no-action letter it sends to investors when it closes an investigation and, more important, will give investors the choice of whether the NASD sends a letter at all.

“This is good news for investors,” says the President of the Public Investors Arbitration Bar Association, which has been trying for years to change the NASD no-action letter and policy.

And clearly, there have been many other improvements at the NASD since 1996, when the SEC blasted the association for failing to investigate trading abuses in the Nasdaq Stock Market. The agency ordered the NASD to spend $100 million to beef up market surveillance. The NASD also has boosted its collection rate for fines and sold off its financial interest in the Nasdaq Stock Market. Schapiro is widely credited for shepherding many of these changes.

In January, the NASD fined Credit Suisse First Boston $50 million for giving stock in hot, new Internet companies to institutional investors only if they agreed to buy more stock in the aftermarket.


Small consolation

All this is little comfort to Craig Jones.

In 1996, Jones, who owns 50% of an accounting firm in Los Angeles, trusted Bruce Campbell, a broker at InterFirst Capital, to manage his retirement savings of about $680,000. Today, Jones has just $70,000 left. He has had to charge $64,000 on his credit cards to pay for margin calls – which are orders to repay a loan used to buy stock, if the stock drops in value.

Jones, 45, has filed an arbitration claim against Campbell, claiming the broker invested Jones’ money in risky Internet stocks without his permission. As the stocks fell, Jones did not have enough money left to pay $191,000 he owed in capital gains taxes on an earlier stock sale. “He has wiped me out of cash,” he says. “I raided my (accounting) firm to pay last year’s taxes. Then the margin calls started coming, so I started dipping into my credit cards.”

And this isn’t the first time Campbell has been accused of abusing investors’ trust. Since 1990, 10 investors have filed arbitration claims against him, alleging he misrepresented investments, conducted unauthorized trades, and bought and sold stocks simply to generate commissions. His previous employers – Lehman Bros. and Smith Barney – had to pay out $372,500 to settle the claims.

The New York Stock Exchange also fined Campbell $3,500 and suspended him for two weeks in 1994 for unauthorized trading. Both Georgia and Maryland denied to license Campbell because of his record.

Jones was outraged when he learned, too late, about Campbell’s trail of disgruntled clients. “When someone like my broker, who has so many complaints against him, can still be out there handling the public’s money, something is wrong,” he says. “And the NASD is just watching. It’s very disturbing. I’ve been wiped out … and I’ve got to try to recoup my retirement.”

Campbell now works for Brookstreet Securities in Pasadena, Calif. He did not return calls for comment. Calls to InterFirst Capital were not returned.

Jones did not complain to the NASD because his lawyer, David Harrison, says, “It will be a waste of time. They are not going to do anything, and it will only hurt us in any arbitration.”

The NASD declined to comment on the case or any other regulatory inquiry in arbitration.

Still, a growing number of lawyers agree with Harrison. “We tell all our clients now, as a matter of policy, ‘Do not complain to NASD enforcement,’ ” says Pat Sadler, a lawyer in Georgia who serves on the NASD’s national arbitration and mediation committee. He adds, “Our cooperation with the NASD cannot help our customer. It can only hurt them.” That’s because arbitration panels usually follow the NASD’s lead.


Payback time

Last year, the NASD took disciplinary action against nearly 1,300 stockbrokers and firms. The association has the power to suspend or expel a member, as well as levy fines and seize ill-gotten profits. NASD can also order a broker or firm to repay an investor but rarely does. It collected just $6.3 million in restitution last year. Brokers and firms who do not pay up are expelled from the industry, but the NASD does not have the legal teeth to enforce a restitution order.

Barry Goldsmith, executive vice president of NASD enforcement, says that many times the brokerage firm, which could be sanctioned for failing to supervise an errant broker, will cover the investor’s losses, eliminating the need to assess restitution.

But Schapiro says, “If you want your money back, if that’s what’s really motivating somebody, arbitration is where they go. They don’t come to us to get their money returned to them.” She adds that NASD has started to place a higher priority on getting restitution for investors and will continue to do so.

Many lawyers and investors don’t go to the NASD for another reason: Most disgruntled investors ultimately get a letter from the NASD saying it is closing its investigation without taking any disciplinary action. “We call that no-action letter the ‘kiss of death,’ because we know it is going to be used against us in arbitration by the brokerage firm,” Harrison says.

He says he hopes the new letter and option not to receive a letter “will allow the NASD to look into the complaint from their perspective without penalizing or prejudicing the investor’s arbitration.”

Angry over past no-action letters, many lawyers have stopped cooperating with NASD investigators, making it harder for the association to punish bad brokers. That was true in Thomas Petruzelli’s case.

In late 1997, Petruzelli got an unexpected letter from a clearinghouse telling him some of the bonds in his portfolio were in default. Two years later, four more of his bond holdings went sour.

“It was a domino effect, and I was scared,” he says.

His broker, Vincent Cestone, had invested Petruzelli’s retirement savings in risky bonds instead of tax-free municipal bonds, as Petruzelli had requested, according to arbitration documents.

Petruzelli, a retired dentist in Bonita Springs, Fla., lost more than $200,000 and had to pay more than $9,000 in margin loan interest, which brokers charge on money investors borrow to buy stocks or bonds.

Because Cestone left his firm, J.B. Hanauer, a few weeks before Petruzelli filed his case, the NASD opened an investigation. They tried to interview Petruzelli, but his lawyer told the NASD he wanted to wait until the arbitration case was over because he was afraid of getting a no-action letter.

And that’s just what happened. When Petruzelli showed up at his arbitration hearing in June 2001, lawyers for J.B. Hanauer had a poster-size copy of the NASD no-action letter.

“It was the only exhibit they blew up,” says Christopher Vernon, Petruzelli’s lawyer. Petruzelli still won and was awarded $231,000 in punitive damages, but Vernon says the no-action letter “could have really damaged our case and was a hurdle to overcome.”

Cestone started a money management firm in New Jersey called V.C. Management. He referred questions to his lawyer, Marc Powers, who notes that the arbitration panel ordered Cestone to pay just $10,000 of the award, while his former firm had to pay the rest.

The NASD’s Goldsmith says the association didn’t take any disciplinary action against Cestone because Petruzelli didn’t cooperate with its investigation and because some of the alleged misconduct dated back to 1995. He also says the NASD may have reopened the investigation after the arbitration hearing, but they never received any information from Petruzelli.

Petruzelli and Vernon didn’t help the NASD after the arbitration because, Vernon says, “I didn’t have enough respect for the NASD investigators to take the time to give them more materials. … The timing of (the no-action letter) was almost ridiculous. They spend nine months on the investigation and couldn’t wait 30 more days until the arbitration was over?”


A hole in enforcement

Investors, as a result, often go through arbitration and never file a complaint with NASD’s enforcement division. But investors aren’t alone in failing to report bad brokers to the NASD for disciplinary action. Arbitration panels also rarely refer even the most egregious cases to NASD for enforcement.

Wall Street firms settled 60% of last year’s arbitration cases before they even got to the panel – the vast majority in favor of the investor, according to the NASD. And of the cases that went before an arbitration panel, investors won more than half of the time.

But if so many investors are winning cases, some critics ask why more brokers aren’t being punished.

“And even after the money is paid in a settlement or award, these guys are still in the business, they’re still doing the same thing – and that’s frightening.”

The NASD wouldn’t give USA TODAY the number of arbitration referrals to its enforcement division but conceded “it does not happen with great frequency.”

Mark Maddox, a lawyer and former securities commissioner for Indiana, says disciplinary actions are one of the association’s weaknesses. “The NASD is an absolute joke when it comes to disciplinary referrals from the arbitration panels,” he says.

Schapiro says, “What we need to do there is probably educate arbitrators more to make referrals in cases where they’ve seen egregious conduct.”