FINRA Sanctions Three Brokers for Sales of CMOs to Retail Investors
First Enforcement Action Arising from FINRA's Ongoing Investigations Into Abuses in Marketing and Sales of Mortgage-Backed Securities
FINRA Investigation into Activities at former SAMCO Financial Branch Office Continuing
Washington, DC — The Financial Industry Regulatory Authority (FINRA) announced today that it has barred two brokers from the Boca Raton branch office of the now defunct brokerage firm, SAMCO Financial Services, Inc. - and suspended a third broker for two years - for misconduct in connection with selling complex mortgage-backed securities called Collateralized Mortgage Obligations (CMOs) to retail customers.
Brokers Cindy Schwartz (CRD No. 4649760) and Brian Berkowicz (CRD No. 4787371) were permanently barred from the securities industry. Broker John Webberly (CRD No. 4537337) was suspended. No monetary sanctions were imposed against Webberly due to his demonstrated inability to pay.
"These are FINRA's first enforcement actions arising from our ongoing investigations into abuses in the marketing and sales of mortgage-backed securities such as CMOs to retail customers," said Susan Merrill, FINRA Executive Vice President and Chief of Enforcement. "Brokers and firms have an obligation to ensure that they recommend these securities only to those customers for whom they are a suitable investment - namely sophisticated investors with a high-risk profile. Webberly, Schwartz and Berkowicz failed to fulfill this obligation when they recommended 'inverse floaters' to retail customers with little or no investment experience. And they compounded this misconduct by permitting the head trader to exercise discretionary authority in the customers' accounts to purchase CMOs."
A CMO is a security that pools together mortgages and issues shares - called "tranches" - with various characteristics and risks. The underlying mortgages serve as the collateral for the CMO and provide principal and interest payments to shareholders.
One of the most volatile and risky CMO tranches is the "inverse floater CMO," a thinly traded mortgage-backed security which is typically highly leveraged and vulnerable to a high degree of price volatility. Rising interest rates reduce the interest earned and also may decrease the principal payments to the investor. The reduction in the repayment of principal extends the maturity date, potentially for as much as 30 years. Furthermore, since each inverse floater is uniquely structured and thinly traded, prices used for valuation purposes are determined using theoretical pricing models. These prices are strictly best estimates of value and can vary substantially from prices obtained through actual bidding or market offerings. As a result, buying inverse floaters on margin further heightens the risk of investing in the product.
Since 1993, FINRA (formerly NASD) has published warnings that inverse floaters are suitable only for sophisticated investors willing to take on high levels of risk.
In its investigation of SAMCO Financial's Boca Raton branch, FINRA found that Webberly made unsuitable recommendations to four customers to buy these securities and that in making these unsuitable recommendations, he misrepresented or omitted material facts. FINRA further found that Schwartz and Berkowicz made unsuitable recommendations and misrepresented material facts in connection with sales to two and three of their customers, respectively. All three brokers allowed their supervisor, who was the head trader in SAMCO Financial's Boca Raton office, to improperly exercise discretionary authority to invest in inverse floaters in the accounts of these customers. Webberly's customers suffered realized losses of approximately $250,000 from their investments, Schwartz's customers suffered losses of approximately $95,000 and Berkowicz's customers lost approximately $190,000.
The head trader of that branch office focused his business on purchasing large par amounts of inverse floaters and allocating the shares among the branch's retail customer accounts, utilizing margin borrowing to finance the customers' investments. Webberly, Schwartz, Berkowicz and the other brokers in the office solicited potential customers for the head trader's investment program.
FINRA found that Webberly and Schwartz failed to conduct any suitability analyses - and Berkowicz conducted inadequate suitability analyses - to ensure that inverse floaters were suitable for the customers' individual situations. At the time each broker opened accounts for customers, the brokers knew that the head trader would be exercising discretion in the accounts, yet none of the three brokers obtained written authorization signed by the customers and a firm principal to allow the brokers or anyone else at the firm to exercise discretion in the accounts. After customers opened accounts at the branch, the head trader exercised discretion in their accounts, purchasing inverse floaters for the customers and frequently utilizing margin in their accounts to do so. In some cases, through the head trader's exercise of discretion, those accounts borrowed as much as three times the amount the customers had initially deposited in their accounts.
FINRA's investigation found, for example, that Webberly recommended to two couples with no prior investment experience that they invest in inverse floaters, falsely claiming that inverse floaters could not lose their principal, that there was no risk in margin borrowing costs exceeding the income earned on the investment, and that the investment was risk free. Each couple invested $50,000 in August 2005. Their deposits and margin borrowing of $100,499.75 were used to purchase inverse floaters. Ten months later, in June 2006, their accounts each earned $3,688.01 in interest, but paid $6,848.96 for the funds borrowed on margin. At that time, the shares were sold to satisfy the customers' margin requirements. This resulted in a realized loss for each account of $70,021.77, which exceeded their principal investment.
Similarly, both Berkowicz and Schwartz recommended CMO investments to investors with limited or no prior investment experience and made material misrepresentations about the characteristics of inverse floaters - in some cases describing CMOs as secured government bonds where an investor could not lose any money. Berkowicz and Schwartz also failed to discuss the potential risks of margin use with their customers. A decrease in the value of inverse floaters resulted in the issuance of margin calls and subsequent sales of their customers' CMO holdings - resulting in losses of approximately $190,000 for Berkowicz's three customers and $95,000 for Schwartz's two customers.
In concluding these settlements, Webberly, Berkowicz, and Schwartz neither admitted nor denied the charges, but consented to the entry of FINRA's findings. In addition to his suspension, Webberly is being required to cooperate in FINRA's continued prosecution of matters arising from its investigation into SAMCO Financial's Boca Raton branch office.
Investors can obtain more information about, and the disciplinary record of, any FINRA-registered broker or brokerage firm by using FINRA's BrokerCheck. FINRA makes BrokerCheck available at no charge. In 2007, members of the public used this service to conduct 6.7 million reviews of broker or firm records. Investors can access BrokerCheck at www.finra.org/brokercheck or by calling (800) 289-9999.
FINRA, the Financial Industry Regulatory Authority, is the largest non-governmental regulator for all securities firms doing business in the United States. Created in 2007 through the consolidation of NASD and NYSE Member Regulation, FINRA is dedicated to investor protection and market integrity through effective and efficient regulation and complementary compliance and technology-based services. FINRA touches virtually every aspect of the securities business-from registering and educating all industry participants to examining securities firms; writing and enforcing rules and the federal securities laws; informing and educating the investing public; providing trade reporting and other industry utilities; and administering the largest dispute resolution forum for investors and registered firms. For more information, please visit our Web site at www.finra.org.