From Bryan Forman, Forman Law Firm, P. C.–In an effort to provide our readers with unique perspective of other professionals in the world of investments and securities regulation, arbitration, and litigation, I will occasionally invite friends, colleagues, and other experts to publish a blog piece from their unique perspective.  If you like what they have to say, please say so and forward!  Thanks for reading.

In this Guest Blog Piece, we hear from Edmond (Ed) Martin of Sage Investigations, LLC in Austin, Texas.  Ed brings some unique experience and perspective to “Ponzi Schemes” a topic that has been around for a while and one on which we have often posted (see, “Ponzi Schemes Recommended By Stockbroker—How Can Firms Miss Them”), but one that is likely to experience a resurgence at the end of the recent bull market and the recession possibly brought on as with the Coronavirus Correction as more and more schemes are revealed as the proverbial house-of-cards comes tumbling down.    Ed is a Certified Fraud Investigator, and gained substantial experience working as a Special Agent for the U. S. Treasury and Internal Revenue Service, Department of Justice, Texas State Securities Board, and other government agency types that you never really want to hear from unannounced–you would always rather call them as a victim of a scam.  Ed has investigated all sorts of financial fraud, with a particular emphasis on Ponzi Schemes, and has told his stories on a number of television programs.    See his CV here.  We invite him here to share his perspective on two of the more notorious Ponzi schemes—Madoff and Russell Erxleben, and to highlight a few of the early warning signs for investors.

Beware of Financial Fraud During Troubled Times.

As I sit here on a Sunday afternoon, listening to some tunes and wondering what will be the ripple effect of these strange times, particularly for the retail investor who has enjoyed an 11 year run of a bull market, I for some reason thought of The Clash’s “Should I Stay, Or Should I Go Now?”.  It’s worth a listen…

Who would’a thought that the title and lyrics from the English punk rock band “The Clash” from 1981 might aptly describe the retail investor’s conundrum given the Coronavirus meltdown in the equity markets?  As a retail investor with a sizeable amount of your life’s savings in the market, “should you stay or should you go…?”

How Margin Risk Can Devastate a Brokerage Account.

WAAAAY BACK in January of 2018, I blogged about how trading on margin, even in a prolonged bull market, can have devastating results if (when) the markets dramatically decline.  See, “Investing On Margin—Will Your Chickens Come Home to Roost?”   I was concerned for those investors for which margin investing might be unsuitable, as the outcome can be devastating.  Certainly, there are generations of new investors with a great deal of investment dollars that only began investing real money during this bull market; meaning they have never faced a down market and the margin calls that come with.  This may be a rude awakening.

With the recent Coronavirus Correction (headed toward recession), it is likely that many investors that were investing using margin have suffered significant losses, AND had to sell other securities in order to cover margin calls. In my January 2018 post, I noted that at the end of November 2017, FINRA reported there was more than $627 Billion in margin debit balances in retail customer accounts, compared to $553 Billion at the beginning of 2017, more than a 13% increase in borrowing to invest in stocks (Note:  A margin debit balance represents the amount of money the investor owes the brokerage firm).  Two years later, at the height of the bull market, FINRA reported there was $561 Billion in margin debit balances in retail customer accounts, a ~10% decline from the same statistic from two years before.  Overall, 2019 showed somewhat lower levels of margin than 2018 and 2017, so based on this alone, it would appear that borrowing to invest leveled out at the “end” of the recent bull market.  However, if one were to look at the margin debit levels in 2010-2012/13, margin balances have doubled!  Clearly, investors wanted to leverage their accounts by purchasing securities using margin debt.  But, as the analogy for this post goes, your chickens may come home to roost amid this market correction!

Austin, Texas Investor Wins $ 2.8 Million in Arbitration on Claims Under The Texas Securities Act

Investors in Private Offerings in Texas Have Substantial Tools At Their Disposal Through the Texas Securities Act (TSA).

In February of 2018, we posted a piece about how the Texas Securities Act was a “Powerful Tool For Victims of Oil and Gas Fraud” and we discussed how the TSA might apply to oil and gas investments, as we were seeing a significant number of investors’ inquiries about their investments in private oil and gas deals.  As we noted, the TSA considers “any interest in or under an oil, gas or mining lease” to be a security.  It is true that the TSA is a powerful tool for oil and gas investors that have been lied to about a deal, but the TSA is not limited to just oil and gas deals, but is applicable to the offer or sale of any security or investment contract.   In this post, we highlight one of the firm’s recent awards where our client received all of his investment back, plus interest, costs, and a substantial award for his attorneys’ fees.   The investment was not in an oil and gas deal, but was a somewhat typical investment in a start-up venture.

Financial Exploitation of Elders – What You Need to Know

Due to age and the impairments that accompany it, our elderly population is, unfortunately, at a high risk of being taken advantage of financially.  Elderly investors are vulnerable to financial exploitation and investment fraud due to a general desire to trust their financial professional, and the difficulty of keeping abreast of the ever-changing financial, retirement, annuity and insurance products marketed by Wall Street.

By the year 2030, all baby boomers will be over the age of 65.  By 2035, the amount of people over 65 will be greater than those under the age of 18 for the first time in history.  Naturally, a substantial amount of wealth and retirement savings will be found in this demographic.  However, close to 20 percent of people over the age of 65 have some form of cognitive impairment.  For those over 85, more than half have Alzheimer’s disease of some other form of dementia.  The aging of our investor class presents inherent opportunities for the unscrupulous promoter of unsuitable investments, or those intent on defrauding others.

UBS and other well-known investment firms are currently making the news for marketing Yield Enhancement Strategy (YES) to its clients as “safe” and “conservative  .”  While YES was marketed as a safe way for investors to enhance their income stream, YES was anything but safe.   Brokers that recommended YES strategies to clients without proper due diligence and disclosure, or that recommended the strategy to conservative income oriented clients, likely engaged in broker misconduct, which could make them liable to those clients. Rather than enhance yield, as promised, the strategy actually resulted in large losses.

YES, designed to earn investors more yield during a time when the markets were relatively stable and interests rates low, involved investing in a series of four options for the S&P 500 Index (SPX).  This strategy is also known as an “Iron Condor” Options scheme, and involves an options strategy marketed by some brokers as a low-risk way for investors to enhance the yield from an investment portfolio.  An Iron Condor strategy consists of selling one call spread and one put spread, each with the same expiration day, on the same underlying asset. Used properly, the iron condor is designed to have a high probability of earning a small profit, provided that the underlying security has low volatility.

While YES wasn’t going to make investors a huge yield if successful, its intent to hedge risk and earn small returns was not without risk.  Not only is risk involved, but YES is extremely complicated, making it difficult for most investors to understand.  Because of this inherent complexity, it is possible, even likely, that brokers and brokerage firms recommending the strategy failed to adequately disclose the risks involved, resulting in a lack of understanding on the client’s part. A broker has a duty to disclose all risks associated with an investment and firms must implement adequate risk controls and compliance systems to monitor a broker’s recommendation to engage in YES strategies.  Failure to do so constitutes a breach of the suitability rules, is negligent, and also a breach of fiduciary duty.

Offering bonuses in the form of employee forgivable loans (EFLs) is common in the financial industry, but these so-called bonuses can result in a trap for unsuspecting brokers (see our website here).  While there are a variety of defenses (LINK) available to brokers when a brokerage firm seeks to enforce these EFLs in a FINRA action, the fact is that arbitrators seem to rule against brokers in these matters almost reflexively.  But a couple of novel theories might offer new alternatives.

The Uniform Commercial Code

One potential new defense to an arbitration proceeding to enforce a promissory note is based on the Uniform Commercial Code (UCC).  The UCC is a model law adopted by states throughout the country to insure that certain financial instruments are subject to the same legal requirements nationwide.  The relevant provisions of the UCC for our purposes apply to negotiable instruments, which include, for example, checks and promissory notes.  A negotiable instrument is a signed, transferrable document promising payment to a named payee at a specified time or upon demand.  For example, your mortgage document is likely a negotiable instrument transferrable between banks, which explains how your bank can sell your mortgage to another financial institution, and then you get a notice to send your payments elsewhere.

The Texas Securities Act , when applicable, is an extremely powerful tool for any investor seeking to recover an investment and other damages when they have been a victim of fraud or when the Texas Securities Act (TSA) has been technically violated, and this is particularly true when an investor invests in a private oil and gas deal that may not be compliant with the TSA or when the deal is misrepresented, or perhaps an outright scam.  Oil and gas scams are, in fact, a staple of the enforcement actions brought by the Texas State Securities Board, and even though the Texas State Securities Board often shuts down the scams and the scammers, investors don’t always get compensated for their losses.

With the stock market reaching recent all time highs in late 2017 and going into 2018, private investment will predictably increase, and in Texas, a lot of investment dollars find their way into oil and gas drilling programs and other investments tied to our so-called “black gold.”   One recent Houston Chronicle article made a good case of why we will see more and more money flowing into the oil and gas and drilling sectors in Texas.   In short, with the price per barrel up from lows of last year, and with the Texas economy booming, it is reasonable to predict that there will be much more drilling activity, and investment into drilling activity.  This usually translates to more private investment opportunities for individual investors in the Texas oil and gas sector, and this predictably will attract promoters and other scam artists hoping to exploit gullible and unsophisticated investors hoping to take part in the energized energy sector.  And, surprisingly, it is still common for promoters of oil and gas deals to abscond with investors’ dollars.

Investments in oil and gas can come in many shapes and sizes.  Investors can, of course, invest in a variety of publicly traded securities, including mutual funds, ETFs, Master Limited Partnerships, and specific companies (e.g. Exxon Mobile, Royal Dutch, and many others who are headquartered in Texas) whose share value is tied to the oil and gas industry.  Investing in a public traded vehicle generally eliminates the opportunity for most registration fraud, IF you are investing through a registered broker that makes a suitable recommendation in light of your investment objectives, risk tolerances, sophistication, and financial condition, but when you are investing in a private investment, the potential of securities fraud may be increased.

Today, the Texas State Securities Board (TSSB) announced in a Disciplinary Order the suspension of Jason Anderson, a broker from Beaumont, Texas formerly working in the last two years with each of LPL, Kovack Securities, IFS Securities, and since March of 2017, was seeking registration as an investment adviser with IFS Advisory, LLC (later withdrawn), and then went on to seek registration as an investment adviser with Financial Management Services of America, LLC.   Last year, Mr. Anderson was “indefinitely” suspended by FINRA for failing to comply with an arbitration award, pay a settlement, and/or failing to tell FINRA about the status of that award.   Mr. Anderson has been very busy—-why?  Some of the answers may be found in Mr. Anderson’s BrokerCheck, which reveals a rather concerning string of customer complaints and other problems.  So, is Mr. Anderson suspended?  Yes as a FINRA broker, and yes in the State of Texas, just not for long.

Well, while Mr. Anderson was with LPL between 2007 and February 2016, and perhaps while at the subsequent firms, Mr. Anderson was recommending to many of his clients an active trading program pursuant to a technical analysis.  The Texas State Securities Board called the trading program the “Equity Strategy.”  Similarly, there have been a number of customer complaints, and even a lawsuit filed against Mr. Anderson for his practices with his customers.

Mr. Anderson’s, and hence LPL’s, Equity Strategy involved actively trading stocks based apparently on Mr. Anderson’s belief in his prescient technical analysis.  The Texas State Securities Board stated that Mr. Anderson “did not consider the trading costs, which included commissions…or the impact that such costs would have on the rate of return the Equity Strategy would need to earn to generate a positive return for a client.”  The TSSB noted that for one client, the costs were 30%, meaning that in order for the client to breakeven, the Equity Strategy would have to earn 30%–no small feat for an investor with a moderate risk tolerance!  Not surprisingly, the TSSB concluded that Mr. Anderson did not have a reasonable basis to believe that the Equity Strategy was suitable for his clients because of his disregard of the trading costs (his own commissions), and thus such practice was deemed by the TSSB to be “inequitable practices in the sale of securities” and it suspended Mr. Anderson’s registration.  Hmmm…

While we sometimes hear our politicians scream about someone’s “chickens coming home to roost,” the origin really deals with curses and offensive words and actions that may come back to haunt you.  The old adage suggests your curses and offensive conduct are like young chickens, and will eventually come home to roost–meaning your bad conduct will eventually rebound to cause you harm.   Perhaps investing on margin in a bull market is an apt analogy.

Indeed, all of our accounts should be showing substantial gains in the last 12 months, as the Trump bull market continues to run.  Compared to numbers one year ago, margin investing is on the rise, with more and more accounts showing increasing margin debit balances. At the end of November 2017, FINRA reported there was more than $627 Billion in margin debit balances in retail customer accounts, compared to $553 Billion at the beginning of 2017, more than a 13% increase in borrowing to invest in stocks.  So is this a curse that may rebound to cause you harm?  Maybe…maybe not.

Purchasing on margin carries with it significant risks, particularly in the event of a rapid market decline.  Margin can, for the right situation and the experienced and sophisticated investor be a very good tool to increase returns on certain investments, particularly short term investments, but at the same time, margin can decimate an account in a declining market or when a particular investment’s value declines.   When the stocks in the account decline, or even if the firm believes the overall market conditions are not favorable to margin investing, the account holder may face a margin call.  The rules of FINRA and the exchanges supplement the requirements of Regulation T by placing “maintenance” margin requirements on customer accounts. Under the rules of FINRA and the exchanges, as a general matter, the customer’s equity in the account must not fall below 25 percent of the current market value of the securities in the account. Otherwise, the customer may be required to deposit more funds or securities in order to maintain the equity at the 25 percent level. The failure to do so may cause the firm to force the sale of—or liquidate—the securities in the customer’s account in order to bring the account’s equity back up to the required level. If the account holder does not have sufficient assets, they must either make a deposit of additional funds or securities, or their assets in that account, and possibly other accounts, will be sold so that the firm is not at any risk.  Make no mistake about it, most margin account agreements permit the firm to sell out your investments at any time, without any prior notice to you or consent from you.  Even if your broker promises you that he will call you first, such promises may not be enforceable.  In the event of an acute dip in the market, your account may be sold out at the short term bottom without any prior notice.