Why the ‘one bad broker’ rule matters

Wall Street rewards high-risk behavior in its salespeople, be they deemed brokers, the old-fashioned term, or financial advisers, in the more commonly accepted contemporary tongue.

To illustrate that point, look no further than the widely disparate cases of a hedge fund blowing up and brokers a few years back pumping sales of a risky alternative mutual fund.

On the surface, the recent blow-up of Bill Hwang’s $10 billion Archegos Capital Management hedge fund and three retail broker-dealers reaching settlements over sales of the shuttered LJM Preservation & Growth Fund couldn’t appear any more different — one is a hedge fund managing billions of dollars known for Hwang reportedly taking enormous single stock positions, and the other is an alternative mutual fund with $800 million in assets at its peak.

But look again and the message is clear: At hedge funds and retail brokerage firms, risk is rewarded and even encouraged, while good compliance and perhaps common sense is in scant supply.

The rule is, one bad broker making big bets or selling lousy or misunderstood products can damage or even ruin a firm. So, are firms — from hedge funds to retail broker-dealers — doing enough to keep those brokers and high-risk behaviors in check?

Of course not.

Wall Street, from investment banks to retail wealth management shops, right now is awash in cash from record market highs and unparalleled government stimulus. Such abundance will undoubtedly encourage even riskier behavior by some financial professionals.

“In the context of these types of firms, there really is enormous risk that these brokers can pose,” said Ben Edwards, associate professor of law at University Nevada, Las Vegas. “One of the risks for independent broker-dealer firms is that they are leaner on monitoring, which means they may face more risk from bad broker behavior.”

Translation: IBDs operate on the cheap, particularly when it comes to compliance and supervision.

And three independent broker-dealers, Cambridge Investment Research Inc., Securities America Inc. and J.W. Cole Financial Inc., near the end of last month reached settlements with the Financial Industry Regulatory Industry Inc. that back up the professor’s claim.

Each had one broker selling the clear majority of the LJM Preservation & Growth Fund, a mutual fund launched in 2013 and was aimed at a retail audience.

The fund took bets on stock market swings and shut its doors in February 2018 in the wake of a spike in market volatility, according to a report from Reuters. Its assets dropped from $812 million to $14 million in a month, losing much of its value in a single day of trading.

Cambridge Investment Research in February revealed in a filing with the Securities and Exchange Commission it had been facing an investigation by Finra’s enforcement department into its “due diligence and supervision” related to the sale of the fund.

“Cambridge permitted the sale of LJM on its platform without conducting reasonable due diligence and without a sufficient understanding of its risks and features, including the fact that the fund pursued a risky strategy that relied, in part, on purchasing uncovered options,” according to Finra. “Cambridge also lacked a reasonable supervisory system to review representatives’ recommendations.”

Finra made identical claims against Securities America and J.W. Cole, and each firm agreed to the settlement without admitting to the regulator’s findings.

What’s buried in each of the settlements is that an individual broker was responsible for the clear majority of sales of the LJM fund. At Securities America, one broker sold all $616,000 worth of shares to 33 clients; at Cambridge, one broker accounted for more than 80% of the $18 million in sales.

And at J.W. Cole, one broker was responsible for more than 60% of $1 million in LJM sales, which included customers with moderately conservative risk tolerance.

And the firms have paid the price. Cambridge is paying a $400,000 fine and $3.1 million in restitution to clients, with Securities America agreeing to a $100,000 fine and $236,000 in restitution. J.W. Cole’s fine and restitution are, respectively, $50,000 fine, $164,000 in restitution.

Spokespeople for each broker-dealer did not return calls to comment.

Independent broker-dealers are notoriously thin-margin businesses, but they can’t afford to underspend on compliance and due diligence.

The question that regulators at Finra and the SEC should be asking is: How did one broker at three distinct broker-dealers account for the lion’s share of sales for a high-risk product? But they won’t. Securities regulators notoriously fail to look forward at potential risk and prefer to gaze backward after a product blows up.

The question that senior compliance executives at large broker-dealers should be asking is: Are we spending enough on technology and personnel to track complex trades and products? But they won’t. Many compliance executives are fearful of painting a target on their own backs by speaking up and making demands.

“The level of damage that an agent or broker can do opportunistically is tremendous,” Edwards said. “Casinos are the same way. Imagine if a pit boss goes rogue.”

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