Everyone that hasn't been lost at sea for the past few years has heard of Bernie Madoff. What we typically see in the news are cases of outright fraud like Madoff's: Ponzi schemes, offshore scams, illegal promissory notes, etc. Investment abuses that are much more common, however, are cases where no criminal fraud has been committed. Many investors have been the victims of unscrupulous or incompetent practices on the part of a broker or investment adviser, and these are what we'll address today.

It's worth noting that every CFP® practitioner and Registered Investment Adviser must adhere to a fiduciary standard, which is much more stringent than the suitability standard that is enforced by FINRA and used as a guide by the great majority of the thousands of brokers it supervises. For more on the important differences between these standards of care, view the statement of the Financial Planning Coalition to Congress.

Here are a few of the most common problems:

Misrepresentations and omissions. A broker has a duty to fairly disclose all of the risks associated with an investment. If a brokerage firm misrepresents or omits material facts regarding an investment to you, and you subsequently lose money on that investment, the firm could be liable for damages.

Unsuitable recommendations. In making an investment recommendation to you, a broker must make recommendations that are consistent with your risk tolerance, financial needs and experience, and investment objectives. A broker has a duty to gather essential information in order to understand these factors, as well as the tax considerations, income needs, and the level of return desired. If a broker breaches those duties and makes unsuitable recommendations to you, the broker may be liable. So, for example, an advisor is making an unsuitable recommendation when he recommends that an elderly client of limited means, who requires capital preservation, invest in a speculative investment.

Mutual fund and variable annuity sales abuses. These include the unsuitable sale or replacement of variable, equity-indexed or fixed annuities, the sale of unsuitable mutual fund share classes, or unsuitable switching of mutual funds. Breakpoint selling is another way for the broker to maximize commissions: rather than use suitable funds from the same fund family, the broker sells you funds from multiple families to avoid discounting sales charges. Learn more about annuity abuses.

Over-concentration. Diversification is one of the most important rules of investing, and one of the best ways to control risk and avoid excessive losses. If an advisor concentrates too much of your portfolio into one type of investment (or asset class), puts too much of your money in only one or two different stocks, or buys too many stocks in the same industry, you face a much greater risk of a large loss. A broker who does not properly diversify your portfolio is potentially liable if that investment declines in value.

Inappropriate use of margin. “Margin” trading is borrowing money from your broker to buy a stock and using your investment as collateral. Trading on margin increases your risk of loss for two reasons. First, the customer is at risk to lose more than the amount invested if the value of the security depreciates significantly. Second, the interest being charged to the account adds to the investors costs, thereby requiring the investments to appreciate even more to cover the cost of the interest before the customer realizes a net gain.

Excessive trading/churning. Churning occurs when a broker engages in excessive trading in an account in relation to your investment objectives. A commission-based broker may churn an account in an attempt to generate maximum commissions.

Unauthorized investments. When a broker purchases or sells a security in your non-discretionary account without your prior approval, the broker has engaged in unauthorized trading. A non-discretionary account requires customer contact and consent prior to the execution of each and every trade. A discretionary account does not, but must be opened with a separate authorization agreement.

Failure to follow instructions. A broker has a duty to follow your instructions regarding the entry and execution of orders, and failure to follow your instructions in a timely manner will violate industry rules.

Next month we'll examine how to take action if you suspect that you have been the victim of investment abuse. In the meantime, it is always worth having your investment accounts reviewed by a CERTIFIED FINANCIAL PLANNER™ professional from the Financial Planning Association (FPA).

By FPA member Tim Sobolewski, CFP®, The Financial Planning Center, Amherst, NY and Joanne Schultz, Esq., of Williamsville NY.


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