Broker-dealer Stone & Youngberg have been fined $350,000 and censured by the Financial Industry Regulatory Authority (FINRA) for charging excessive markups on trades of collateralized mortgage obligation securities (CMOs) for retail customers.
The firm was also required to pay about $206,000 in restitution to customers, without interest, per the terms of a Letter of Acceptance, Waiver and Consent (AWC) it submitted to settle the alleged FINRA rule violations. Without admitting or denying anything, the firm consented to FINRA’s entry of findings and FINRA accepted the AWC on Feb. 8.
Stone & Youngberg has been a FINRA registered broker-dealer since 1937. It employs five registered brokers in its principal offices in San Francisco, where it runs an investment advisory business and has obligations under securities remarketing agreements. The firm was acquired by Stifel Financial, the parent of Stifel Nicolaus & Co., in October 2011.
Letter of Acceptance, Waiver & Consent
According to the AWC, from January 2006 through August 2007, Stone & Youngberg charged excessive markups on trades of CMOs. Nor did the firm have adequate supervisory procedures to make sure its CMO markups were fair and reasonable.
In addition, the firm failed to adequately supervise sales of a tranche of inverse floating rate CMOs, and failed to offer written educational materials to its retail customers regarding CMOs prior to trading in them on their behalf.
As a result of inadequate oversight, Stone & Youngberg made at least 242 CMO trades for retail customers for which the firm assessed a markup that exceeded 4 percent of the current market price of the security.
These markups were excessive, that AWC said, in that they were not fair and reasonable when taking into account the circumstances of each trade. The markups — totaling roughly $206,000 — violated the conduct rules of the National Association of Securities Dealers (NASD), a predecessor to FINRA.
Collateralized Mortgage Obligation Securities
A CMO is a fixed income security that pools mortgages together. Tranches are then issued out of the pool with various characteristics and risk levels, the AWC said. Unlike other fixed income products like certificates of deposit or corporate bonds return the face value of the security at maturity, CMOs pay principal and interest throughout their life. The maturity date is the last date by which all of the principal must be returned, and its can vary depending on interest rates.
Inverse Floater CMOs are among the riskiest of CMO tranches, according to a notice that FINRA sent to its members. They pay an adjustable rate of interest that moves in a direction opposite to an interest-rate index, for example, the London Interbank Offered rate (LIBOR). Inverse
Floaters are usually leveraged up and vulnerable to price volatility tied to interest rates. Increased rates may also push back the expected maturity date.
During the period in question, Inverse Floaters were thinly traded in the over-the-counter market, and volatile. FINRA had informed its members that Inverse Floaters were suitable only for sophisticated investors with high-risk tolerance. FINRA also required that any investors be informed of the risks and characteristics of the Inverse Floater being purchased.
Stone & Youngberg began selling CMOs in the spring of 1997. The firm did not originate CMOs, but acquired them for resale to customers by buying blocks of them at a discount from other firms. At first, these CMOs were sold only to institutional customers.
Eventually, Stone & Youngberg allowed brokers to sell certain types of CMOs and Inverse Floaters to retail customers. These included securities issued by the Government National Mortgage Association (Ginnie Mae) as well as the government-sponsored entities Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). The firm also sold private CMOs, some of which carried more credit risk and were less liquid than those issued by the government or government-sponsored entities.
According to the AWC, Stone & Youngberg failed to establish and maintain a supervisory system and procedures for CMOs reasonably designed to achieve compliance with securities laws and FINRA and NASD rules.
The firm first failed to put procedures in place to make sure its CMO markups were fair and reasonable. While Stone & Youngberg’s compliance manual named the two supervisors responsible for reviewing CMO markups, the supervisors did not use any framework to evaluate whether the markups were fair and reasonable.
The supervisors were never instructed on how to assess reasonableness, and the result was the $206,000 charged in excessive markups.
Stone & Youngberg also failed to monitor the suitability of CMO sales to retail customers. The firm’s compliance manual directed that its brokers must have a reasonable basis for recommending securities and that they must consider the other securities held by the customers, as well as their financial situations and needs. Moreover, supervisors were supposed to reviewed customer transactions for suitability.
The firm failed to guide brokers on the assessment of customer suitability for Inverse Floaters, however. Despite a notice from FlNRA to members that this kind of CMO was only suitable for sophisticated investors who were highly tolerant of risk, Stone & Youngberg failed to inform its sales force. The firm allowed its brokers to recommend Inverse Floaters to retail customers who did not understand to the risk, or who had moderate investment objectives not well served by Inverse Floaters.
Finally, Stone & Youngberg also failed to comply with NASD investor education requirements. Firms must offer educational materials before the sale of a CMO to anyone other than an institutional investor. The materials must inform investors about CMOs in general, as well as the traits and risks of the different tranches of a CMO.
Although the firm purchased two educational brochures produced by the Bond Market Association, it left whether these were distributed to brokers’ discretion. In doing so, it failed to comply with NASD rules requiring all retail customers be provided with written educational materials on CMOs.
FINRA public disclosure records reveal that Stone & Youngberg has been subject to eight regulatory actions and has been involved in two arbitrations.
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