Tracy Stoneman - Stoneman Law
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Concentration: Too Much of a Good Thing? (Part 2)

Morgan Stanleys May 2002 Perspectives document states:

Looking to Reduce Risk? Diversification is Key

Suppose you own just one stock and it declines 20%. The value of your portfolio has fallen 20%. Now suppose you have two stocks, and while one drops 20%, the other stays flat. The value of your portfolio, in this case, has declined by just 10%. If you own 20 stocks, a 20% decline in one reduces the value reduces the value of your portfolio by just 1%! Thats how diversification can help to reduce risk and optimize your overall return.

In a document entitled, Five Strategies for Diversifying a Concentrated Position, which was available on Merrill Lynch's website, Merrill Lynch wrote:

A concentrated position is a double-edge sword. When the stocks price is rising, the position can boost the value of an investors overall portfolio. However, when the price falls, the portfolio value will suffer proportionately.

The long held investment norm is that for a stock portfolio to be considered diversified, the stock portion of the account should hold at least 20 (5%) to 30 (3.3%) different stocks. This standard is supported by numerous documents. A November 5, 1997 A.G. Edwards Compliance Note refers to 5% or more in a speculative security as a concentrated position.

Even mutual funds, which are professionally managed, must follow certain guidelines under the Investment Company Act of 1940 (ICA) to be considered diversified. The guideline states that with respect to at least 75% of the fund, the securities of any single issuer do not account for (a) more than 5% of the investment companys assets, or (b) more than 10% of the outstanding voting securities of that issuer. ICA §5(b)(1).

Concentration definitions and levels vary among firms and companies. This makes it all the more important to determine the standards at the respondent firm during the time period at issue standards for the entire portfolio and standards for the equity investments. However, just because the firm had a standard in effect, does not mean that it was an appropriate standard. If the firm had no standards at the time in question, then look to more recent guidelines by the firm, as well as guidelines from other firms, all of which can serve to establish the standard of care that was breached. Do not hesitate to incorporate standards that you find at respectable websites, like the CNNFN example above, either.

IV. The Impact of Margin in Concentration Cases

The use of margin plays a significant role in concentration cases. Stockbrokers have been known to portray margin to clients as a way to diversify the account, and thereby lessen the risks when, in reality, margin increases the risks. An investor on margin is much more susceptible to price swings in the stocks owned and, accordingly, risks having to liquidate either the core holding or the new stocks purchased using margin. The investor not on margin, on the other hand, has the ability to weather price drops without being forced to take action. Even Olde Discounts 1993 Compliance Manual stated Investing in one security, a few securities, or securities in the same industry exposes the customer to greater risk, especially in a margin account.

With more frequency, we have seen the situation where an employee of a publicly traded company opens a brokerage account with a deposit of a huge amount of his company stock acquired through employee stock options. Brokers may mislead clients into believing that there is no need to sell the company stock and that, instead, diversification can be accomplished by using margin and purchasing additional securities. The problem is that the broker has not lessened that clients risk in the concentrated position. The client has the same exposure in terms of risk of loss if the stock nosedives as he did when he came to the firm. For this reason, margin is not an effective tool to lessen the risk in a concentrated position.

Diversification works in the absence of margin, because in order to diversify, the client has to sell some of the underlying security, which in turn lessens the risk of the concentrated position.

Ask your clients if the broker brought up margin as a way to diversify. Explore the brokers financial incentives to utilize margin. In a commission based account, margin increases the accounts buying power and the brokers ability to generate commissions. Establish that what the broker made in subsequent margin purchases was greater than what he would have made if he had sold some of the concentrated security. If the broker was compensated on a percentage or flat fee basis, show that the broker made money by margining the account, since such compensation is based on the market value of the account, as opposed to the equity. Compare this to what the broker would have made if he had recommended that a portion of the underlying security be sold - nothing.

Margin almost never decreases the risks, and almost always increases the risks. If the broker or brokerage firm argues that the use of margin diversified the account and thus lessened the risks, it will be clear that the firm not only misled your client, it is trying to mislead your arbitration panel.

V. Brokerage Firm Defenses to Concentration Cases

Brokerage firms utilize a variety of tactics to defend concentration cases. First, they often paint a picture that your client is a speculator, and so the concentration was not unsuitable. Second, they may attempt to show that there was no concentration by, what we call, diversification by hindsight. Third, they almost always blame the investor for loving the stock or the industry and wanting to load up on it. Where possible, the firm will support that claim with evidence that the broker marked the order tickets unsolicited. And finally, if your client came to the firm with the concentrated position, they will claim no duty. Each of these defenses can be dealt with as follows:

A. Your Client Was A Speculator

The classic defense to almost any claim that hints of unsuitability is that the client had speculation as an investment objective and, hence, the firm had carte blanche to recommend anything and everything. The problem with such a premise is that it presupposes two things that undermine the premise. The first is that even stupid recommendations are suitable and the second is that historical precepts for investing no longer have any validity.

A true speculator, be he in real estate or stocks, takes calculated risks by conducting research and using historical data to measure and evaluate the potential risk and return. The true speculator doesnt make stupid investments. And he doesnt throw out the window the historical precepts regarding investing. He probably makes rather intelligent investment decision; they just happen to be higher risk. It has been written that the speculator is the advance agent of the investorthe road to success in speculation is the study of values.5

Though you likely dispute the contention that your client was a speculator, you may be able to show that the conduct in question failed to meet the investment objectives of speculation, assuming for the sake of argument, their validity.

B. Diversification Through Hindsight

In determining the percentage of concentration, the top number or numerator in the equation - is the dollar value of the concentrated position, whether that is a single security, a group of high risk securities, or a particular industry. There is usually little dispute about that figure.

However, in one of Mr. Schulzs recent cases, where the registered investment advisor had placed roughly 80% of the investors account in technology stocks, at the arbitration the advisor attempted to dispel the concentration by fiddling with the numerator. The advisor contended that the technology stocks were not really technology stocks per se, but rather could be broken down into the following different and diversified industries: hardware, software, communications, micro-chips, etc. Do not let your arbitration panel be fooled by this unsupportable argument. There are roughly 10 accepted sectors, and not all of them are technology. 6

More commonly, brokerage firms muddy the water by attempting to increase the denominator. Doing so results in a lower percentage of the concentrated position, perhaps so much so that it enables the firm to argue that there was no concentration.

This is the same tactic used by brokerage firms and their experts in churning cases. In determining the turnover number, brokerage firm experts try to use the market value of the account as the denominator, as opposed to the account equity, which is the accepted way to perform the calculation. It is ironic that firms want to use the account value figure as the denominator the figure that evidences that the firm margined the account and, by definition, increased the risk to lower the turnover number, thereby masking the risk level of the account. Fortunately, regulators have rejected these defense arguments. See, In the Matter of Dean Witter, et. al., SEC Administrative Proceeding File No. 3-9686 (2001)(SEC accepted claimants turnover and concentration calculations).

What figure you use for the denominator will depend upon the facts of your case. Again look to any pronouncements by the firm in question. Merrill Lynch states that it does not include other assets, such as the value of life insurance policies or business interests, in its asset allocation analysis because this type of asset may not be readily reallocated. Under that theory and generally speaking, the value of assets in a separate IRA account should not be a part of the denominator, nor should other accounts that are earmarked for specific purposes or specific goals, such as a trust fund for a childs education. Additionally, brokerage firm attempts to look to assets in accounts outside the firm to lessen the concentration figure usually fail and are viewed as Monday morning quarterback behavior.

C. It Was The Clients Idea - Confirmations Are Marked Unsolicited

At one end of the spectrum, we have the situation where the broker has marked all of the purchases resulting in the concentrated position unsolicited, meaning it was the clients idea. Yet, your client has told you that none of the transactions were her idea. We have seen numerous cases involving this fact pattern.

In this situation, it is critical that you obtain the brokers unredacted commission runs in discovery, the document that shows all of the brokers transactions in all of his accounts. By unredacted, we mean other customers account numbers are not fully redacted so that you can see how many different accounts there are. The NASD Discovery Guide speaks to such redaction, however, it is faulty in that it only mentions unredacted commission runs being discoverable in churning cases. This is presumably because the issue of control is an element of churning claim. If the broker had all or many of the same investments in his other clients accounts, this would be evidence that the broker controlled the clients account.

Unredacted commission runs are equally important in concentration cases. The brokers mismarking of order tickets can be swiftly refuted by showing that the broker was making the same trades in other clients accounts. When making this argument in the pre-hearing conference, point to language in the respondents answer claiming that the trades were the claimants idea to show that the same issue of control exists in your concentration case.

Even where a claimant affirmatively seeks to engage in highly speculative or otherwise aggressive trading, a broker is under a duty to refrain from making recommendations that are incompatible with the customer's financial profile. See, In re Gordon Scott Venters, 51 S.E.C. 292, 294-95 (1993); In re John M. Reynolds, 50 S.E.C. 805, 809 (1992). This is especially true where a brokerage firms recommendation leads to a high concentration in the customer's account of a particular security or group of securities that are speculative. See, e.g., In re Clinton Hugh Holland, Exchange Act Rel. No. 37991, at 8 (Dec. 21, 1995), aff'd, 105 F.3d 665 (9th Cir. 1997).

Oftentimes brokers, in defense of a concentrated position, will testify that they advised the client against the concentration levels but the client insisted on it. Make sure you find out where the broker and/or his supervisor documented this unsuitable activity. Some firms such as A.G. Edwards, Dean Witter, and First Union state in their compliance manuals that their brokers are not required to accept trades that they think are unsuitable but if they do, they must, at a minimum, document the incident. Some require the broker to obtain a signed unsolicited letter from the client.

At the other end of the spectrum, do not think you are safe if the purchases that collectively resulted in the concentrated position were solicited by the broker (meaning the confirmations do not say unsolicited). We have had cases where brokers testified that they did not check unsolicited on the order ticket because, for example, the stock was on the firms recommended list which meant an automatic solicited trade. Nonetheless, the brokers testimony was that it was the client who called up begging to load up on more of the stock. Again, ensure you obtain the unredacted commission runs. If there are just a few trades in other clients accounts in the same security, you may need to make a second request for the order tickets for those trades to actually see how they are marked. Its not too late if you first confront this situation in the arbitration. We had one panel order the production of order tickets in other customer accounts to examine this very issue right in the middle of the arbitration!

Lastly, we have encountered brokers who think that an adequate defense to a concentration claim is that the investor was consulted on every purchase and never complained about the concentration. We have found that defense to be ineffective. A broker has a duty to make suitable recommendations; the mere fact that the client goes along with the strategy does not somehow relieve the broker of that duty.

D. The Investor Was Concentrated Upon Arrival at the Firm We Didnt Do It

There has been a rash of complaints by individuals who accumulated large blocks of employee stock options. If the individual worked for one the successful tech or telecom companies, it was not uncommon for such folks to have become millionaires almost overnight. Many of these employees flocked to brokerage firms for advice on not only how to handle the exercising of their employee stock options, but also for investment advice on their accumulated wealth. Many companies directed their employees to brokerage firms with which the company had a relationship, for the purposes of having the firm counsel the employee regarding the stock options.

This scenario also raises concentration issues, except that opposed to the broker having recommended the concentration; the investor has comes to the broker with the concentration in hand.

Many times, instead of recommending that the client liquidate some or all of the concentrated position or hedge it, the broker recommends that the client retain it. The broker may advise the client to use margin to pay the taxes and to pay the cost of the option stock price and, as we discussed earlier, may recommend that the client use margin to diversify the account. We have seen time and time again where this combination of using margin to handle the options and using margin to buy more stocks was a disaster waiting to happen.

If a broker improperly induced a client to hold a security, there is authority that such conduct is negligent. See NYSE Interpretive Memo No. 90-5 which defines recommendation to include a brokers influence to hold a security and NYSE Rule 405 which requires due diligence to learn essential facts of every account. If you can establish a fiduciary relationship between the client and the broker or advisor, then such relationship gives rise to a duty to speak or act. Insurance Co. of North America v. Morris, 981 S.W.2d 667, 674 (Tex. 1998). Such a failure to act gives rise to liability. See, In re Saxton, 712 N.Y.S.2d 225 (N.Y.App.Div., Aug. 10, 2000) and Matter of Estate of Janes, 659 N.Y.S.2d 165, 681 N.E.2d 332, 90 N.Y.2d 41 (N.Y. 1997)(fiduciary retained stock in inadequately diversified account while the stock lost substantial value); In re Rowe, 712 N.Y.S.2d 662 (N.Y.App.Div., Aug. 10, 2000) (a fiduciary can be found to have been imprudent for losses resulting from negligent inattentiveness, inaction or indifference.).

If your client arrived at the brokerage firm in a concentrated position, whether it be because of stock options or a previous negligent firm, your client may have a viable claim.

VI. Using Graphics to Present Your Concentration Case to the Panel

Charts and graphs are very useful tools in a concentration case. The unsuitability of concentration delivers much more of a punch when the arbitrators are staring at a color, graphic presentation. The classic illustration is the pie chart wherein the pie is investors entire portfolio and the pieces of the pie are broken down by sector and percentages.

Asset Class Concetration Graph

Additionally, bar charts can be used to illustrate the same point.

Asset Class Concetratiion Graph

Its also quite effective to display, for example, the percentage of technology stocks versus non-technology stocks in a bar chart.

Concetration of Tech vs Non-tech Securities Graph

Charts and graphs can tell your clients story in a vivid manner that will hammer home the points you need to make in a concentration case.

VII. Conclusion

NASD statistics reflect a record number of arbitrations claims being filed by investors who have sustained record losses. The brokerage industry would have the investing public and arbitrators believe that this is no fault of theirs, but rather the responsibility of the bear market. For at least the last decade, almost every brokerage firm and defense law firm has argued to arbitrators that comparing the investors losses to the markets was improper. They claimed that lost opportunity damages and market comparative analysis was not appropriate.

How quickly they have changed their tactics. Now, these same brokerage firms and defense lawyers fill their answers and exhibits with charts showing what the investor would have lost in the market. The more aggressive defense lawyers dare to compare the clients losses to the NASDAQ, the most speculative of indices. Yet, hardly a claimants lawyer compared clients losses to the NASDAQ when it was doubling.

But there is justice. Hopefully, you have an experienced panel that will remember the defenses dislike for market comparison damages. If not, dig out answers from some of your earlier cases. Make them an exhibit and show the panel the hypocrisy. To bolster that same point, obtain the firms television and print ads during the time period of your clients account. The arbitration panel may find quite a contrast between what the firm was representing to the public compared to a) what it did to your clients portfolio; b) what it stated in its answer, and c) the positions it takes at the arbitration.

With Henry Blodgett and Mary Meeker pushing tech and Jack Grubman pumping telecom to their brokers and the investing public, it is not happenstance that millions of investors ended up concentrated in volatile, speculative securities. The sad reality is that millions of investors not only paid for this advice in the form of commissions and fees, but they also paid for it with their life savings.

  1. An argument could be made that the least conservative investor would choose c), however, our rationale was that the risk taker is a mover and shaker and needs access to his funds for risky ventures.
  2. This result was obtained on June 30, 2002 by going to, clicking on calculators and then selecting asset allocator, answering the questions and clicking on get allocation.
  3. This chart was obtained on June 30, 2002
  4. Some firms also pay their brokers a percentage of the margin interest paid by the client.
  5. Philip L. Carret, The Art of Speculation, 1975.
  6. Merrill Lynch, on some of its CMA Account statements, lists the following 10 sectors: Financials, Services, Consumer Staples, Consumer Cyclicals, Capital Goods Technology, Capital Goods Industrial, Energy, Basic Industries, Transportation, and Utilities. Morgan Stanley, in its May 2002 Perspectives document, lists the following 10 sectors: Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Telecommunications Services, and Utilities.
Concentration: Too Much of a Good Thing? (Part 1)
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