Capital Securities Management, Inc., a brokerage firm and investment adviser firm from Glenn Allen, Virginia, was censured and fined $470,000 after consenting to Financial Industry Regulatory Authority (FINRA) findings that the firm engaged in unsuitable sales of reverse convertible notes; charged excessive commissions; failed to establish, maintain, and enforce an adequate supervisory system and written supervisory procedures pertaining to reverse convertible notes sales, commissions charged, and private securities transactions. Letter of Acceptance, Waiver and Consent, No. 2011025548801 (Oct. 20, 2015).
According to FINRA, reverse convertibles are complex structured products which take the shape of interest-bearing notes where the principal repayment is linked to the performance of a reference asset (typically a stock, basket of stocks, or index). Upon maturity, if the value of the reference asset has fallen below a certain level (referred to as the knock-in level), the investor could face a loss of principal. Thus, the reverse convertibles expose the investors to issuer risk along with risks of decline in value in the underlying reference asset. The products have limited liquidity and complex payout structures, making it difficult for registered reps and their customers to accurately assess costs, risks, and benefits of investing.
FINRA, via Notice to Members 10-09, instructs firms to make reasonable efforts to perform suitability analysis with customers concerning reverse convertible notes, considering that they expose investors not only to risks traditionally associated with bonds and other fixed income products (e.g. issuer default, inflation risk), but also additional risks of underlying stocks, potential for loss of all or a port of the principal, and the illiquid nature of the reverse convertible notes. FINRA calls for firms to uncover information concerning the customer’s tax status, investment objectives, and other information as necessary for purposes of ensuring the reverse convertibles are only sold to persons whom the risk of the products is appropriate for.
According to the AWC, from January 1, 2008 through August 31, 2011, CSM, via Stockbroker RS, recommended and effected twenty-four unsuitable purchases of customized reverse convertible notes which totaled approximately $4,000,000 in accounts of eight of the firm’s customers. The AWC indicated that the majority of the customers were over age sixty and had modest or conservative investment objectives and risk profiles. The AWC noted that $80,000,000 in reverse convertible notes were sold to retail customers, including 63,500,000 in nine customized offerings. In four of the customized offerings, the stock price of the linked securities dropped below the “knock in” price, and stocks were put to the customers at maturity, resulting in losses.
The AWC stated that the customers’ accounts were heavily weighted in the reverse convertible note sales, where the amounts of such investments comprised a significant portion of the customers’ net worth. FINRA found that such recommendations from RS were unsuitable considering the customers’ risk tolerance, investment objectives, ages, and net worth. FINRA found that the firm violated NASD Conduct Rules 2310, 2110 and FINRA Rule 2010 in this regard.
Further, according to the AWC, the firm had failed to establish, maintain and enforce a supervisory system along with written supervisory procedure reasonably designed to supervise the sale of reverse convertible notes to retail customers. Specifically, FINRA claimed that the firm’s procedures that addressed the reverse convertible notes were inadequate because they did not provide guidance regarding the consideration of customer-specific suitability (e.g. customer account types, income levels, investment experience, objectives suitable for the reverse convertible investments). FINRA found the firm violated NASD Conduct Rules 3010, 2110 and FINRA Rule 2010 in this regard.
The AWC additionally stated that from January 2009 – February 2013, CSM had failed to apply sales charge discounts to eligible unit investment trust and mutual fund purchases. The AWC indicated that customers ended up paying excess sales charges of $18,254.10 as a result of the firm not applying discounts to unit investment purchases, while customers paid $14,089.21 in excess sales charges pertaining to mutual fund purchases as a result of the firm not applying breakpoint discounts to 43 eligible Class A share mutual fund purchases. FINRA found that the firm violated NASD Conduct Rule 2110 and FINRA Rule 2010 in this regard.
FINRA found that the firm had failed to establish adequate supervisory procedures to ensure that customers received sales charge discounts on eligible unit investment trust and mutual fund purchases as well. FINRA found this conduct to be violative of NASD Conduct Rule 3010 and FINRA Rule 2010.
The AWC goes on to indicate that from January, 2009 through March, 2010, the firm charged customers excessive commissions on four hundred and twenty-one equity transactions. Such transactions, according to the AWC, carried commissions exceeding both five percent of the principal amount invested and $100, resulting in excess commissions paid of $32,784.13. FINRA found the firm’s conduct to be violative of NASD Conduct Rule 2440 and NASD IM-2440-1, and FINRA Rule 2010.
FINRA, via Conduct Rule 2440, states that if a FINRA member buys for his own account from his customer, or sells for his own account to his customer, he must buy or sell at a price which is fair, taking into consideration all relevant circumstances. If the member acts as agent for his customer, the member cannot charge his customer more than a fair commission or service charge. NASD has indicated that mark-ups of five percent may be construed as unreasonable.
CMS, according to FINRA, failed to establish adequate supervisory procedures to ensure that commissions charged were being reviewed. FINRA found this conduct to be violative of NASD Rule 3010 and FINRA Rule 2010.
Finally, form January 2009 through March, 2010, the firm had failed to establish, maintain, and enforce supervisory systems to record and supervise private securities transactions. FINRA found this conduct to be violative of NASD Rule 3010 and FINRA Rule 2010. Selling away, also known as private securities transactions or undisclosed outside business activities, occurs when a stockbroker engages or participates in the sale of securities to investors outside of the formal approval of the securities firm with whom they are associated.
Guiliano Law Group
If you have been the victim of securities fraud and you have a complaint, you should consult with an attorney. The practice of Nicholas J. Guiliano, Esquire, and The Guiliano Law Group, P.C., is limited to the representation of investors in claims for fraud in connection with the sale of securities, the sale or recommendation of excessively risky or unsuitable securities, breach of fiduciary duty, and the failure to supervise. We accept representation on a contingent fee basis, meaning there is no cost unless we make a recovery for you, and there is never any charge for a consultation or an evaluation of your claim. For more information contact us at (877) SEC-ATTY.
