Broker Made 600K, One Couple Claims

Broker Made 600K, One Couple Claims: Levitt Flicks the Switch on a Scam

January 29, 2001
By David Hoffman
Investment News

When Alan and Mimi Vella, two orthodontists from New Jersey, got a call in the early 1980s from the person who would become their broker, they’d never heard of a little-known scam called “switching.”

But now they are all too familiar with the term.

In a complaint filed in June with the National Association of Securities Dealers, they claim that their broker at PaineWebber Inc. in New York made about $600,000 in commissions through mutual fund switching and other questionable trading in their account.

The case highlights a practice that Arthur Levitt , departing chairman of the Securities and Exchange Commission, says is a growing concern.

Mr. Levitt chose his last town hall meeting with investors to sound an alarm.

“In recent years, we’ve … seen a surge in a practice called switching,” he said.

Problems arise when industry professionals induce investors to switch funds, even when the costs to them greatly outweigh the benefits, solely to generate commissions for themselves, he said.

Industry experts are divided on whether the practice of switching has actually increased or is just getting more attention from the federal government.

One thing they all agree on is that switching, a variation on stock churning that is more associated with annuities, has gone on for years.

They say it’s a way in which brokers increase their commissions, usually without anyone noticing.

One lawyer who represents both investors and brokers calls it “nibbling.”

“There are ways that unscrupulous people can take advantage of the system without taking a very large chance of ever suffering any particular harm as a result,” says Vincent DiCarlo, a lawyer in Sacramento, Calif.

“Generating excess commissions [through switching], unless it’s wildly in excess, is unlikely to result in the kind of harm that’s going to make somebody mad enough to bring a claim [against brokers],” he says.

But that doesn’t mean it can’t affect an investor’s bottom line over a period of time, says Allan Fedor, a Largo, Fla., lawyer who represents investors.

little visibility

Brokers “will do it on a very limited basis, and usually they’ll get away with it,” Mr. Fedor says.

“The only people that will see this stuff … are the tax preparers that see a tax return from year to year. That’s where it will come up, and that’s where investors will see it.”

Critics claim one of the reasons the practice is so invisible is that switching is a matter of disclosure.

If a broker fails to inform the investor of the charges and commissions involved in switching from one mutual fund or annuity to another, that investor is left in that dark.

And although most rules governing securities trading practices are quite clear, those about switching are vague at best.

The SEC and the NASD have long held that high turnover rates of mutual funds are not consistent with the concept of investment, and the NASD has sanctioned many brokers and financial advisers for violating that principle. But for the most part, brokers are left to police themselves.

“I think it’s a fairly common practice for most of these broker-dealer firms to have a control procedure in which, before a switch is effected, the client has to sign off on what’s called a switch letter where the client acknowledges receiving prospectuses and other pertinent information and has decided to make the switch,” says Gene Gohlke, associate director of the SEC’s office of compliance inspections and examination.

“That seems to be a pretty good control procedure, particularly if persons above the registered representative regularly review those switch letters, look for patterns and look for instances where the switch seems unsuitable.”

Neither the SEC nor the NASD, however, requires that switch letters be sent out, let alone regulate the information contained in such letters.

“In terms of switching letters, we don’t micro manage firms in telling them exactly what letters to send out or what language to use,” says Nancy Condon, a spokeswoman for NASD Regulation Inc. in Washington.

“Our rules speak more generally. We do expect fair dealings with customers, and that includes disclosure of fees and changes to accounts.”

That could be why Mr. Levitt sees a surge in switching, which officials at both the SEC and the NASD say is nearly impossible to prove with hard numbers, because the complaints aren’t tracked.

problem with letters

Lawrence Klayman, whose firm, Klayman & Lazarus LLP in Boca Raton, Fla., represents the Vellas, says the switching letters the PaineWebber broker sent on at least five occasions told them nothing about the fees they would have to pay as a result of switching mutual funds.

Each letter tells the Vellas to “allow this letter to serve as an acknowledgment of your trades … as well as verification that at the time these trades were entered, you were aware of the fact that they were subject to certain sales charges and may have possible tax consequences to you.”

Mr. Klayman maintains that letters sent to the Vellas were unusually vague, differing from an example letter included in PaineWebber’s own broker manuals.

But other lawyers who have represented clients in switching cases say letters like the ones the Vellas received are common.

Despite such comments, switching still doesn’t get the publicity other forms of fund fraud get despite the fact that the practice appears to occur on a regular basis.

In addition to the charges being leveled at PaineWebber, the NASD has brought sanctions over the years against numerous brokers and financial advisers for switching.

And the SEC recently jumped in by bringing its first switching case.

In September it charged Raymond Parkins Jr. in Orlando with inducing his investment advisory clients to switch their variable-annuity investments by providing them with unfounded, false and misleading justifications for the switches.

Mr. Levitt said in his speech in Philadelphia that as a result, investors allegedly paid more than $168,000 in unnecessary charges and even lost some of their original investment.

Mr. Parkins, on the other hand, allegedly earned an extra $210,000 in commissions.

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