Taking Stock of your broker Dishonest ones can slip through cracks, going from firm to firm ruining accounts


When Charles Knell retired a decade ago with a $350,000 nest egg, he and his wife entrusted their money to D. Jeffrey Rice, the son of the Knells' best friends and a broker at Alex. Brown & Sons.

Their goal was not to get rich, but merely to provide for a quiet lifestyle in southern Florida. Who better to leave their money with than Alex. Brown, Baltimore's pre-eminent investment banker, and Mr. Rice, a respected friend of the family?

The mistake was costly. Within five years, nearly three-quarters of their money was gone. The Knells, with just $100,000 in their account, were stunned. They filed a complaint, charging Mr. Rice with mismanaging the account and trading just to generate commissions for himself. The couple, now in their early 70s, settled the case with Alex. Brown for $150,000 in 1992.

The bitter story ended there for Charles and Jeanne Knell -- but not for Mr. Rice.

With two large settlements already behind him, the former Gilman School senior class president left Alex. Brown in 1990 just as the Knells discovered their losses. Hired by PaineWebber Inc., he began again -- with a new employer and new customers unaware of all his past problems.

The result: PaineWebber last fall fired Mr. Rice for allegedly stealing $3 million from 25 customers over the past three years.

Mr. Rice's track record does more then tell an unfortunate and costly tale of the dangers of the market in general, and the role of brokers in particular. It is equally illuminating and profoundly disturbing for the industry as a whole.

Mr. Rice and others like him, referred to in the industry as "rogue brokers," have been targeted by industry leaders, regulators and lawmakers as the biggest threat to maintaining public faith in the nation's securities industry.

Although relatively few, these brokers are able to wreak damages, both to their customers' finances and to the industry's reputation, far beyond their numbers. Just a few well-publicized cases can involve millions of lost dollars and sully the reputations the nation's largest brokerage houses.

But many tales remain unreported, private losses that pit the small investor against the numerous failings and conflicts inherent in the self-policed brokerage business. What these investors have learned so painfully is the safety of their money can be placed at severe risk by simply opening an account to buy or sell securities.

Among the problems:

* Brokers are paid to make trades, not to make profits, and they rarely inform customers about the incentives that drive them to buy and sell.

* Brokerage firms, driven by high costs and intense competition, are hesitant to crack down on productive salesmen, regardless of their disciplinary records.

* Problem brokers with big client lists find it easy to jump from firm to firm, aided by employers who are reluctant to say anything bad about a former employee.

* Disciplinary proceedings are shrouded in secrecy that can protect these rogue brokers for years.

* The general lack of public disclosure of disciplinary actions makes it nearly impossible for investors to discover the truth about their brokers.

"It's the retail customer who believes that all this protection is in place, when in fact there is a nationwide, low-level buzzing of anarchy," says Patrick G. Finegan Jr., a Washington securities attorney and former in-house brokerage lawyer.

"Regulation is a myth," he maintains. "It is a destructive, fraudulent myth."

The problem has become so pervasive that the Securities and Exchange Commission, which supervises the brokerage industry, and Congress have responded with a torrent of speeches, hearings and studies in the past six months. The SEC and the National Association of Securities Dealers (NASD) last -- month announced that everyone in the industry who deals with customers will have to take consumer education and ethics courses.

Regulators say they recognize the severity of the problem, which has taken on added importance recently as a new generation of unsophisticated investors, repelled by low interest rates at banks and lured by booming Wall Street markets, turned to stockbrokers.

But some downplay the scope of the problem, arguing that the few chronic abusers are quickly caught and banished from the industry.

"We are satisfied with [the regulatory system]," says Joseph R. Hardiman, president and chief executive of the NASD, which is both the brokerage industry's largest trade association and, because of the authority given to it by the SEC, its chief regulator. "Is it perfect? No. But we are generally satisfied with it."

Misplaced confidence, trust

It is unlikely that the clients of Mr. Rice would agree.

Although the parties involved declined to discuss the case at length, details of their story came from allegations against him by PaineWebber, the Knells, and others, as well as publicly available documents, and from some of the Knells' friends.

The Knells had every reason to believe their money was safe with Mr. Rice.

The Knells and Mr. Rice's parents were best friends as well as neighbors in Baltimore's Northwood section, a middle-class neighborhood where Mr. Rice was raised.

Mr. Rice attended Gilman School, where he won the school's coveted Fisher Medallion for all-around achievement. After graduating from Princeton University he eventually settled into a large home in the Guilford neighborhood of Baltimore. With a respected position at the nation's oldest investment bank, he led a comfortable life that included antique buying and wine tasting.

So when Mr. Knell retired, selling his truck dealership in 1984 and moving to Florida, he and his wife turned to Mr. Rice.

The Knells had little experience in investment matters and seldom examined their account statements. It wasn't until 1990 that they began to realize the extent of their losses.

Alarmed, they confronted Alex. Brown with evidence of Mr. Rice's actions, including allegations of unauthorized trades, risky investments unsuitable for a retired couple, "churning" -- or rapid trading to generate commissions -- and even an account document that a handwriting expert hired by the Knells determined was forged with the Knells' signatures.

After a year of haggling with Alex. Brown, the Knells were near bankruptcy, and decided to settle the case one week before a planned arbitration hearing. They received $150,000, including $50,000 from Mr. Rice, according to a national data base managed by the NASD.

Now they are selling their Vero Beach, Fla., condominium and moving back north.

The couple declined to discuss the case. Mr. Knell made only one comment: "I'm going to have to go back to work, and that's something I certainly hadn't counted on at age 71."

What the Knells didn't know was that they weren't the only ones who had problems with Mr. Rice. Before he left Alex. Brown, two other customer complaints were filed against him, leading to total settlements of $185,000.

"You hear that all the time -- it's terrible," said Annapolis attorney Charles Bagley, who represents securities clients in arbitration cases. "Unfortunately, it's a standard situation."

System primed for abuse

Incidents of the type alleged against Mr. Rice occur among only a small number of the nation's half-million registered stockbrokers, industry members argue. Most brokers work hard to promote the best interests of their clients.

But critics charge that the seeds of abuse find fertile soil in an industry that worships sales, and a compensation system that ++ effectively encourages abuses and deters self-policing.

Most stockbrokers, while bearing a fiduciary responsibility to their clients, make money only by selling products, whether or not it's in the customer's best interest. And the people who are directly responsible for guarding against unethical sales practices by brokers find their own compensation tied to the same incentives for abuse.

This commission-based system is an "ethical cancer . . . one that is cured not by chemotherapy, but instead by litigation and ruined careers," SEC Commissioner J. Carter Beese told the industry at a December conference of the Securities Industry Association in Florida.

Not even the largest firms are immune. In St. Louis last fall, a Prudential Securities stockbroker was sentenced to five years' probation and ordered to pay restitution to a dozen elderly clients. He was convicted of defrauding them of more than $1 million by making unauthorized trades and misleading statements about his customers' accounts.

And just this month the top bond trader at Kidder, Peabody Group Inc., a unit of General Electric Co., was fired for allegedly recording $350 million in phony bond trades. The scheme, which harmed only GE and not the firm's customers, helped boost the trader's income to $9 million last year.

Brokers, on average, keep 30 to 45 percent of the commissions they generate. Commissions can range from a half percent to 10 percent of the size of the investment.

A respectable level of commissions can run from $200,000 to $300,000 a year, but some top brokers produce $750,000 and more for their firms. As such, their value as employees matches the size of their "book."

"This industry is very free-agent oriented," said John C. Coffee Jr., who teaches securities law at the Columbia University School of Law. "There's a lot of effort to hire brokers with substantial commissions."

When Mr. Rice moved to PaineWebber in 1990, for example, he was paid an inducement of $400,000, he told several former clients. In 1992, he was named to the company's "President's Council," which honors some of PaineWebber's top salespeople in the nation.

"The pressure on these guys is enormous, they're under intense pressure to produce," says Paul Van Sant, who left the Hunt Valley office of PaineWebber with a partner several years ago to start their own firm in Lutherville. Each day, the office manager circulated a list ranking every broker according to the previous day's production, Mr. Van Sant says.

"To be on the bottom of that list is shameful, especially if you've been given a big upfront payment to come, and you're supposed to be a big producer," he explains. "The whole system is designed to punish and humiliate the people at the bottom, and reward the people at the top."

Many large firms shower prizes on the brokers who sell the most high-priced products.

In July 1992, for example, winners of a PaineWebber life insurance sales contest won a four-day "working" trip to Quebec. A glossy brochure described all the other prizes available -- from color televisions to diamond bracelets to Rolex watches -- and the amount of commissions needed to win them. Often these brochures are sent home to spouses, to increase the pressure. High-pressure telephone scripts given to the brokers rarely mention the risks involved or the hidden incentives that may drive the broker.

And the rewards are heaviest for the riskiest products. A $10,000 purchase of relatively safe municipal bonds can cost an investor $50 to $100 in commissions. But the same amount placed in more speculative investments, from real estate limited partnerships to oil and gas syndicates, can typically result in $600 to $1,000 in commissions.

"They've all got to produce," said Mr. Bagley, a partner in the Annapolis law firm of Council, Baradel, Kosmerl & Nolan, P.A. "You've got a quota to make -- as a broker and as a manager -- and if you don't do it, you're outta there."

The branch managers, the industry's designated first line of defense, are subject to the same "cancer" as the brokers. They are blamed for the abuses that transpire in their offices, but are paid according to the profits of their branches. Usually without a book of business of their own, office managers are dependent on their firms, and often impotent to reign in a top producing broker.

"[Managers] are hired to be fired," says Mr. Finegan, the securities lawyer. "Upon the slightest disruption of calm seas they are the ballast that's tossed over."

Client list opens doors

But the brokers find it easiest to resurface. A big book of business is a powerful calling card that allows some top salespeople to move easily from firm to firm, regardless of their record.

Consider the case of Baltimore broker Peter R. Schanck.

In the last half of his career, Mr. Schanck has been the subject of more than a dozen customer complaints, alleging almost $1 million in losses, and resulting in public settlements approaching $90,000.

PaineWebber, which had paid Mr. Schanck a "forgivable loan" of more than $500,000 to leave Shearson Lehman Bros. in 1990, fired him last year for falsifying customer account documents, according to the company, court filings and the NASD data base. That record also shows that he was censured and fined $5,500 in 1988 by the NASD in connection with charges that he recommended unsuitable investments to a client when he was a broker at Shearson.

Mr. Schanck, in an interview, dismissed the customer complaints as a normal byproduct of his thousands of client relationships during 28 years in the business. He said many of the complaints were not valid, and that more than half were lodged because his former colleagues wanted to steal his accounts after he moved to another firm. "The complaints say nothing about me as a broker," he said. "In almost every case we've satisfied the client" afterward.

And he said PaineWebber's allegations surrounding his firing in February last year were unfounded.

Despite his record, less than a month later, Mr. Schanck had a job with Peregoff Rottman Barron Inc., a small Baltimore brokerage.

"The regional broker is delighted to get you," Professor Coffee says of large producers. "They may know [about disciplinary problems], but you've got $1 million in annual commissions. That would increase a regional brokerage's annual revenues by 10 percent."

Peregoff's chairman, Ira Peregoff, says he was attracted partly by Mr. Schanck's annual production, which exceeded $1.5 million in commissions in 1992.

Mr. Peregoff said Mr. Schanck has "always been one of the top producers in Baltimore. Of course," he said, "that has some influence [in the hiring process], but it's not worth it" if a broker causes an expensive lawsuit.

Mr. Peregoff said that after examining Mr. Schanck's record and talking with several clients, he was satisfied that Mr. Schanck was "a good person, he's top-notch." When he was hired, the state securities division conditioned his broker's license on heightened supervision by his manager.

Then last fall, the state initiated steps to revoke his license for allegedly selling unregistered securities. Mr. Schanck denies the allegations in that case, which is still pending.

Lack of candor by firms

Mr. Schanck's case is an exception: His departure from PaineWebber was extraordinary in that Peregoff actually knew that he was fired. Ordinarily, brokerages avoid putting black marks on a former employee's record, even though regulations require them to report the reasons for a broker's departure to the NASD computer data base.

"Many firms are frankly wary about being totally candid as to the reason for the termination, because they're fearful of the litigation," the NASD's Mr. Hardiman said, adding that his group is pushing for liability limits for employers who merely state the facts on a broker's record.

Mr. Rice's record, accessed through the NASD's computerized Central Record Depository, reveals nothing about the reasons he left Alex. Brown.

But there was evidence that he had other unreported run-ins with Alex. Brown customers before he left, according to current and former Alex. Brown employees, as well as PaineWebber, which has been investigating his past.

"I have enough indication that suggests to me that permitting this individual to resign was not the appropriate course of action," said Joseph Grano, president of the company's retail division and chairman of the NASD.

"If this gentleman's previous firm had information that this individual may have been a bad apple and didn't pass that on either verbally or [in written form], then I'm going to hold them accountable," he said.

Alex. Brown acknowledges the existence of only the three recent complaints, saying they "were resolved to the customers' satisfaction," said spokeswoman Jami McDonald. "Each of those complaints was reported to the appropriate regulatory agencies in a timely manner in accordance with applicable rules," she said. "None of the complaints alleged misappropriation of client funds."

Mr. Rice is cooperating with PaineWebber, the firm said, adding that all clients will be reimbursed for any funds missing from their accounts. Out of the industry now, Mr. Rice would not comment, except to say, "It was my business between me and my clients and PaineWebber, and I'm satisfied with the way things stand."

On March 28, Mr. Rice signed a statement admitting to the Maryland securities division that he stole about $3 million from clients' accounts while at PaineWebber, made unauthorized trades, and lied about the value and existence of his customers' securities. The state, while reserving the right to take further actions, barred Mr. Rice from the securities industry in Maryland for life.

But except for the most extreme cases, such as Mr. Rice's, regulatory sanctions are rare, according to lawyers and some industry members.

In 1991, when there were 406,106 registered brokers nationwide, the NASD received 3,519 complaints from customers and either suspended or barred from the industry 749 people. Last year, which ended with 463,836 brokers, almost 4,000 complaints were made and the NASD suspended or barred 632 people.

Mounting crackdown

Some regulators acknowledge the gravity of the situation, and maintain it's now being taken seriously.

"In the past it has been too easy for brokers with substantial compliance histories to jump from firm to firm and leave their records behind," Mr. Beese, of the SEC, said in an interview.

And he issued a stern warning when he spoke to the industry: "I am here to tell you, the commission will not tolerate the presence of rogue brokers in our markets," he said. "If you don't eliminate them, we will," he added, "and those with supervisory responsibility will be held accountable."

As part of that effort, he said his agency has stepped up its crackdown on deceptive sales practices by large brokerage firms.

The SEC has launched a systematic examination of the records of brokers at all of the nation's largest firms, he added, a project that already has uncovered evidence of practices such as excessive trading, unsuitable recommendations and

unauthorized trading.

Even Congress may get involved. It's awaiting separate reports from the SEC and the General Accounting Office on the problem of repeat offenders, due in June. One possible solution is a "three strikes and you're out" rule, though it's unclear how such a law would define a "strike." In any event, the industry has opposed the idea.

Partly out of enlightened self-interest, the firms have started to get serious about rogue brokers, according to Samantha Rabin, senior editor of Securities Arbitration Commentator, a Maplewood, N.J., newsletter and data base company.

"The legal expenses are really hitting the bottom line. They are coming to the attention of the presidents and CEOs," Ms. Rabin adds. "And when it gets to that level it becomes important."

For some, the recent attention is a heartening sign that the industry finally may be ready to rid the securities business of its worst elements.

But others fear it's just more talk.

"A particularly noteworthy problem is that of the dishonest, but high-producing [broker] who roams from firm to firm," the SEC's chairman said in a toughly worded speech in Florida. "In this crucial time it is in Florida. "In this crucial time it is important for the public to know that the industry is committed to maintaining high ethical standards and to protecting the public from securities law violators."

That speech was made by former SEC Chairman David S. Ruder. In 1987.

Tomorrow: With a lack of public disclosure in the brokerage industry, how do investors protect themselves?

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