Gone are the days of the penny stock and the “chop stock.” In the old days, in addition to house stocks, brokers would trade “lunch-time” stocks. A lunch time stock is a stock that trades “a quarter to one,” i.e. the bid is a quarter or 25 cents, but the offer is $1.  So if a firm can accumulate stock at 25 cents, and sell it at a dollar, for every $10,000 invested, the broker can make 75% or $7,500. In fact, under the Rules, since the broker did not “mark-up” the stock over the lowest prevailing offer price, i.e. $1.00, your brokerage firm does not even have to disclose its 75% de facto “commission” or even be concerned with FINRA’s Mark-Up “policy” or “guidelines” limiting compensation to generally 5%, depending upon on a variety of factors, which are also not relevant here.

However, Investors are wary of penny stocks. Regulators are increasingly vigilant about firms selling low priced securities, or any securities, sold as “principal,” generally with huge and often undisclosed gross trading profits or mark-ups over cost, so the bucket shops have caught on to a new gig: Why not do the same thing with fixed income securities or bonds and make substantial profits based upon the spreads associated with bonds, including bonds having maturities in excess of 30 years, where any mark-ups in their price, (thereby decreasing their  “yield to maturity”) would go virtually unnoticed.

Bonds May Seem Conservative to the Investor

Bonds sound conservative, or at least more conservative that low priced stocks, and are easier to sell to the unsuspecting investor. FINRA is less focused on “bond” transactions, because even to them and the firm’s compliance departments, “bonds” are generally not speculative investments, and are not unsuitable per se.

In January 2012, the Financial Industry Regulatory Authority brought two such actions against Southwest Securities, FINRA Enforcement Action 2009-0174178 (Feb. 11, 2011) and FINRA Enforcement Action  2008-0160239 (Jan. 10, 2012), each finding that the Company purchased and/or sold certain municipal and other securities from its “customers at an aggregate price (including mark ups and mark downs) that were not fair and reasonable taking into consideration all relevant factors including the best judgment of the broker-dealer as to the fair value of the securities at the time of the transactions.”

However, we are beginning to see more and more the short terms trading in fixed income securities with huge spreads, and also deceptive sales practices with respect to unrated or speculative bonds and Tobacco Bonds, which are often falsely portrayed, despite higher yields as being safe or “fully secured,” backed by the full faith and credit of the respective state tobacco fund. However, in almost all cases, the bond, are “junk” or are not rated, nor are backed by the full faith and credit of the State. In fact, these Bonds, “do not constitute a debt, liability or obligation of the State or any public agency of the State (other than the Agency) or any Member of the Agency, including the County. The County is under no moral obligation to make payments of principal of or interest on the Bonds in the event that Revenues are insufficient for the payment of principal of, or interest or redemption premiums on the Bonds.”

Moreover, the repayment of the bonds is conditioned upon the ability of the tobacco manufacturers to pay the tobacco settlements, which could be adversely affected by a number of considerations, including the future solvency of the tobacco manufacturers, and on going litigation, in several U.S. District and Appellate Courts throughout America, including in California, that the tobacco settlement agreements violate certain provisions of the United States Constitution, including the Commerce Clause, state constitutions, the federal antitrust laws, state consumer protection laws and unfair competition laws, some of which actions, if ultimately successful, could result in a determination that the tobacco settlement agreements are void or unenforceable.

Muni Market Investor Advocate

In fact, the, the U.S. State and Local Public Finance Watchdog and Muni Market Investor Advocate, issued a Special Report Worst Spreads in 2010, listing the Golden State Bonds as Number 3, with a bid of 81.738 and an offer of 93.182, or a spread of 11.44 per bond, meaning that a broker-dealer could “cross” these bonds by paying a selling customer the 81.738 bid, and resell them at the 93.182 offer per bond, and thereby realize an instant 14% profit, exclusive of any “mark down” to the seller or “mark-up” to the purchaser.

In many cases, we are also seeing these bonds sold at one price, i.e. the offer price, but only days later where the market value, or bid price, is shown on the monthly customer statement, that the customer can see a loss of between 10-20% of their principal investment.

Also, in many cases, because the bonds are bought or sold with “accrued interest,” where for example the buyer who may only own the bonds for a month or so may receive an semi-annual interest payment, a part of which is due the former owner, it is often difficult to tell, at least on a gross proceeds basis, whether or not the bond transaction, at least on the basis of price, was profitable or not.

Despite efforts to rationalize or justify the short term trading of these bonds based upon interest rate movements, these price of these bonds are generally based upon credit risk, and less on interest rate movements. Unless the bonds go into default, and investors continue to receive their interest payments, they are often non-the-wiser. Also, most often when these bonds, which are sold at unfair prices to begin with, lose value, the offending brokerage firm will argue that if we include interest payments, the customer has no appreciable losses, sort of like the story that if a customer invests $100 in a 10% bond and receives $10 per year for ten years, but wakes up to find his or her bond worthless, that the customer has no losses because they received their $100 back over 10 years.

Bonds Include Risk

Risky bonds, including unrated bonds and tobacco bonds, include great risk. If interest rates double, a 30 year bond may lose 40% of its value. Bonds, unless you hold them to maturity and can accept credit risk until maturity, include risk, and the short term trading of bonds, which are not designed as short term trading vehicles, are almost never appropriate for an individual or non-institutional investor.

Guiliano Law Group

Our Practice is limited to the representation of investors in claims against stockbrokers and investment professionals for fraud, the sale of unsuitable investments, breach of fiduciary duty, failure to supervise. National Practice. Contingent Fee. Free Consultation. If you have suffered losses a the result of the recommendation of inverse and leveraged ETFs by your stockbroker or investment professional and were unaware of the risk associated with these securities, contact us for a free confidential evaluation at (877) SEC-ATTY.