Monday, May 16, 2016

Smaller Brokerage Firms Are Even Worse!

By Craig McCann, PhD, CFA , Chuan Qin, PhD and Mike Yan, PhD, CFA, FRM

Last week we posted Have 1.3% or 7.3% of Stock Brokers Engaged in Misconduct? explaining that the competing estimates of broker misconduct differ because of differences in their definition of misconduct and the sample of brokers studied.

Firms with 400 to 999 Brokers Are Much Worse Than Larger Firms.

In last week’s post, we listed the 100 highest risk brokerage firms with 400 or more registered brokers sorted by the percentage of their brokers associated with Investor Harm Events as of December 31, 2015 as defined by the FINRA study, “Do Investors Have Valuable Information about Brokers?” available here. The 10 highest risk firms with more than 400 brokers, listed below in Figure 1, are the same 10 firms whether using the FINRA study definition or Egan, Matvos and Seru’s broader financial misconduct measure from “The Market for Financial Adviser Misconduct”, available here.

Figure 1: 10 Highest Risk Firms with More Than 400 Brokers, December 31, 2015
Nine of these 10 firms – Aegis Capital, Summit Brokerage Services, National Securities, Centaurus Financial, Independent Financial Group, Kovack Securities, Wedbush Securities, Investors Capital Corp. and Wunderlich Securities – have between 400 and 999 brokers and so are not included in Egan Matvos and Seru’s Table 6 reproduced here as Figure 2. That is, 9 of the 10 highest risk firms with more than 400 brokers have fewer than 1,000 brokers. And the worst of these firms with more than 400 brokers are twice as bad as the worst firms in Egan Matvos and Seru’s Table 6 which has brought so much attention Oppenheimer, First Allied and Wells Fargo Advisors.

Figure 2: Egan Matvos and Seru’s, page 37, Table 6



The Smaller Firms Are Even Worse!

The brokerage firms with fewer than 400 brokers are even worse than the brokers with between 400 and 999 brokers. Figure 3 below relaxes the threshold to include firms with 100 or more brokers. There are 32 higher risk brokerage firms with 100 or more brokers before we get to Oppenheimer sorted by brokers with Investor Harm Events. 26 of these 32 higher risk firms have fewer than 400 brokers each. On average, 17.9% of the brokers at these 26 firms with between 100 and 399 brokers have had at least one Investor Harm Event compared to 17.0% of the brokers at the six firms ranked higher risk than Oppenheimer with more than 400 brokers.

Figure 3: 42 Highest Risk Firms with More Than 100 Brokers, December 31, 2015

It’s Ethics, Not Product Failure

UBS Financial Services of Puerto Rico has the highest percentage of brokers registered as of December 31, 2015 associated with an Investor Harm Event in Figure 3. This is perhaps not surprising given the large number of customer complaints filed over UBS Financial Services of Puerto Rico’s closed end bond funds. (You can read our February 12, 2015 summary blog post, “UBS Puerto Rico’s Bond Fund Debacle: What We Know So Far” here.)

Some commentators have incorrectly asserted that assessing brokers based on customer complaints is unfair because it tars good brokers with the results of a failed product promoted by their employer. While this might occasionally happen, it is surely the exception not the rule.

First, the rankings in Egan Matvos and Seru’s Table 6 covering firms with more than 1,000 brokers and our tables covering brokers with more than 400 or more than 100 brokers identify firms not brokers. To the extent a large number of brokers received customer complaints because of a faulty product promoted by their firm, the identification of these firms as high risk is a service to investors.

Also, even at firms which have been identified with a large product failure like Morgan Keegan with the RMK Funds, Citigroup with MAT/ASTA and UBS with the Lehman Brothers structured products the vast majority of brokers were not subject to customer complaints. If a broker has a lot of customer complaints related to a product failure the broker likely bears some significant responsibility.

Finally, brokers with a customer complaint in one year are far more likely to have customer complaints in the next year, the second year, the third year and so on. If the extent of customer complaints was related in any meaningful way to product failures, we wouldn’t see the persistence we observe in the data.

Wednesday, May 11, 2016

Investors Lose Over $7 Billion in SandRidge Energy Stock and Notes

By Brian Henderson, PhD, CFA  and  Craig McCann, PhD, CFA

In recent months, investors have lost billions of dollars as a result of their investments in SandRidge Energy, Inc. stock, notes and bonds. Sandridge is involved in the exploration and production of oil and natural gas in the continental United States with some interests in the Gulf of Mexico.

SandRidge’s stock price has lost 99% of its value since 2014, erasing more than $4 billion of market capitalization. In addition to near complete losses to SandRidge stockholders, investors have lost billions of dollars in SandRidge notes. SandRidge Energy has multiple classes of notes outstanding, the traded prices of which are presented in the following figure. Across all outstanding SandRidge Energy notes, investors have suffered approximately $3.3 billion losses.

Price Chart of SandRidge Energy INC Notes


All classes of SandRidge Energy noteholders have suffered staggering losses. The Senior Notes (unsecured) are trading at roughly 5 to 6 cents on the dollar. At these prices, noteholders are expected to receive less than one year’s worth of interest and recover virtually nothing through bankruptcy. Even SandRidge Energy’s recently issued Senior Secured Notes (issued June 10, 2015) plummeted in value virtually right out of the gates (see CUSIP EK945529). Those Senior Secured Bonds, with roughly $1.3 billion principal outstanding, trade as of April 2016 at roughly 20 cents on the dollar.

SandRidge fell victim to the recent decline in global oil prices. The following figure illustrates the decline in oil prices and the corresponding declines in SandRidge Energy’s stock price. In the Fall of 2014, crude oil prices began falling from their highs of $105/barrel, reaching the mid $50s by the end of 2014 and declined further in early 2016, falling as low as $26.2 per barrel.

Losses to Sandridge Energy shareholders have been more severe than to other oil and gas exploration companies, as illustrated in the following figure from SandRidge’s own 10-K filing:


SandRidge Energy is a highly leveraged company, and thus its earnings are more sensitive to decreases in revenue as a result of lower energy prices. SandRidge’s debt-heavy capital structure and dwindling liquid reserves left no margin for the type of large losses incurred when oil and natural gas prices declined during 2015 and 2016. These losses have eaten through most of SandRidge Energy’s shareholder equity, as illustrated in the following excerpt from SandRidge’s 8-K filed March 29, 2016:


SandRidge Energy’s most recent financial statements provide insight into why investor losses have been so severe. The majority of SandRidge Energy revenue comes from oil, natural gas, and natural gas liquids (NGL), the values of which decreased significantly over the past two years. Correspondingly, revenues decreased 21% year over year for 2014, followed by a 51% decrease for 2015. Although the company describes itself as an oil and gas exploration and production company with other interests in related businesses, the revenue breakdown illustrates that this is not a diversified company, it is one heavily concentrated in exploration and production.

Revenues Plummet:

 
Losses would have been worse without hedging:

SandRidge used derivative contracts to hedge against declining energy prices. The following table illustrates that those hedges provided positive cash flows which increased the net revenue per unit of output for all energy products. The company’s hedging policy provides some cushion in the near term, but will cease to supplement revenues should low energy prices persist for longer periods.



Valuation of reserves plummeted from $5.5 billion at the end of 2014 to $1.3 billion at the end of 2015:


The valuation of reserves has decreased due to both falling prices for energy commodities and the closing of existing wells necessitated by declining energy prices’ impact on revenues. Analysis of the expenses enumerated on SandRidge Energy’s Income Statement reveals a $4.5 billion impairment charge as a result of write-downs.

The overall picture emerging from the financial statements, and supported by the market prices for SandRidge Energy’s notes and stock, indicates that low energy commodity prices have crippled the company and that it is on the verge of bankruptcy. Most shocking are the low recovery rates to noteholders implied by the prices of SandRidge notes. Should energy prices remain low for a sustained period of time, SandRidge Energy will almost certainly be forced to file for bankruptcy protection.

Investors Losses

The magnitude of losses to SandRidge Energy investors is staggering. Noteholder losses exceed $3 billion, and equity investors have lost more than $4 billion.

Despite their high yields and seniority, Sandridge Energy bonds are risky. Investments in all classes of Sandbridge securities come with heavy exposure to volatile energy commodity prices. Those risks are easily diversifiable, and SandRidge Energy investments should have been, at most, very small portions of investor portfolios. Proper diversification limits investor losses from any one security, such as SandRidge Energy.

Unfortunately, many financial advisors concentrated client portfolios with large allocations to SandRidge Energy bonds or notes, chasing the higher yield promised by these notes during a low interest rate environment. Some investors had nearly all of their portfolios in these securities. Those investors with overly concentrated portfolios of SandRidge securities suffered large losses and may have recourse to recover those losses.



Tuesday, May 10, 2016

Have 1.3% or 7.3% of Stock Brokers Engaged in Misconduct?

By Craig McCann, PhD, CFA , Chuan Qin, PhD and Mike Yan, PhD, CFA, FRM

In our recent working paper How Widespread and Predictable is Stock Broker Misconduct? we reconcile estimates of misconduct, demonstrate that broker misconduct is predictable and explain that ostensibly publicly available BrokerCheck data could be used to help investors avoid bad brokers and bad brokerage firms if only it were made truly public instead of only speciously so.

Jason Zweig's recent column in the Wall Street Journal Is Your Broker Good or Bad? discussed our research problem. In this post and two subsequent posts we boil down our research into these three main topics.

Three recently published research reports have analyzed customer complaints, regulatory actions and other financial disclosures by brokers using FINRA BrokerCheck data. The studies report widely different assessments of the extent of broker misconduct.

In Do Investors Have Valuable Information about Brokers?, Qureshi and Sokobin from FINRA's Office of Chief Economist analyze publicly and non-publicly available BrokerCheck data on 181,133 brokers and find that 2,349 of the brokers registered with four or more states for at least half their careers, or 1.3% of the total studied, had at least one customer complaint during the period from 2000 to 2013 which resulted in an award or settlement above a $10,000 threshold before May 18, 2009 and above a $15,000 threshold thereafter. Thus, it appears from Qureshi and Sokobin, that misconduct is rare in the brokerage industry.

In The Market for Financial Adviser Misconduct, Egan, Matvos and Seru using the BrokerCheck data covering a slightly different time period - 2005 to 2015 - found that that 7.3% of brokers have financial misconduct disclosures on their record and that brokers remain in the industry despite repeated misconduct. Egan, Matvos and Seru use a more expansive definition of broker misconduct than Qureshi and Sokobin, and this explains in part why they find so many more brokers may have engaged in financial misconduct.

In our How Widespread and Predictable is Stock Broker Misconduct? we reconcile such divergent estimates of misconduct. We find that 20,010 or 4.9% of brokers currently registered with 4 or more states have resolved customer complaints which meet Qureshi and Sokobin's definition of investor harm events.

The difference between our results - 20,010 brokers versus 2,349 brokers and 4.9% versus 1.3% of brokers - is thus not as a result of differences in the definition of investor harm. Our results differ primarily because we include brokers registered before 2000 and those brokers who are far more likely to have customer complaints were excluded in the FINRA study.

Our research and Egan, Matvos and Seru find that bad brokers concentrate in bad brokerage firms and the existence of concentrations of bad brokers help predict future misconduct by co-workers not yet revealed to be bad. Thus, avoiding firms with high concentrations of bad brokers is a good start for investors trying to protect themselves from broker fraud.

The following table lists the top 100 brokerage firms with 400 or more registered brokers sorted by the percentage of their brokers associated with investor harm events as defined by the FINRA study as of December 31, 2015.

Company NameRegistered BrokersInvestor Harm RateMisconduct RatePreviously Fired Rate
AEGIS CAPITAL CORP.44424.10%35.14%4.73%
SUMMIT BROKERAGE SERVICES, INC.67619.08%30.92%9.62%
NATIONAL SECURITIES CORPORATION76018.03%31.58%5.53%
CENTAURUS FINANCIAL, INC.60216.28%27.74%6.48%
INDEPENDENT FINANCIAL GROUP, LLC63814.11%27.43%7.84%
KOVACK SECURITIES INC.43413.36%28.57%13.13%
OPPENHEIMER & CO. INC.221712.45%19.53%4.15%
WEDBUSH SECURITIES INC.63412.15%20.98%5.05%
INVESTORS CAPITAL CORP.64111.23%20.44%6.08%
WUNDERLICH SECURITIES, INC.45911.11%21.79%4.58%
UBS FINANCIAL SERVICES INC.1255510.97%14.84%0.75%
FIRST ALLIED SECURITIES, INC.117910.35%17.05%4.16%
NEXT FINANCIAL GROUP, INC.7969.42%17.21%2.64%
VSR FINANCIAL SERVICES, INC.5119.39%12.72%1.37%
STERNE AGEE FINANCIAL SERVICES, INC.5809.14%18.97%6.03%
WELLS FARGO ADVISORS FINANCIAL NETWORK, LLC19938.83%14.95%1.51%
AMERICAN PORTFOLIOS FINANCIAL SERVICES, INC.8388.71%16.95%4.30%
MORGAN STANLEY SMITH BARNEY LLC237828.68%12.81%0.63%
RAYMOND JAMES & ASSOCIATES, INC.58128.40%13.20%1.74%
JANNEY MONTGOMERY SCOTT LLC13698.33%13.88%2.12%
STIFEL, NICOLAUS & COMPANY, INCORPORATED45888.28%13.19%2.46%
SIGMA FINANCIAL CORPORATION6788.11%14.16%2.80%
INVESTACORP, INC.5007.80%16.20%3.40%
WELLS FARGO ADVISORS, LLC263197.59%12.12%1.17%
SECURITIES AMERICA, INC.26627.18%13.67%2.29%
UNITED PLANNERS' FINANCIAL SERVICES OF AMERICA5106.86%15.49%3.73%
GIRARD SECURITIES, INC.4776.50%15.30%3.98%
CETERA ADVISORS LLC16186.49%13.60%2.97%
NATIONAL PLANNING CORPORATION18156.45%13.88%2.09%
PURSHE KAPLAN STERLING INVESTMENTS, INC.12296.35%12.21%2.69%
PARKLAND SECURITIES, LLC4646.25%13.36%2.37%
D.A. DAVIDSON & CO.9146.24%10.39%1.64%
RBC CAPITAL MARKETS, LLC52506.06%9.66%0.86%
RAYMOND JAMES FINANCIAL SERVICES, INC.54615.91%11.33%1.96%
KMS FINANCIAL SERVICES, INC.4525.75%10.62%2.43%
QUESTAR CAPITAL CORPORATION8245.70%12.38%2.06%
SII INVESTMENTS, INC.8095.69%10.75%1.36%
ROYAL ALLIANCE ASSOCIATES, INC.21535.62%11.01%1.81%
MERRILL LYNCH, PIERCE, FENNER & SMITH INCORP.332885.53%8.41%0.29%
SAGEPOINT FINANCIAL, INC.22785.31%11.81%2.77%
J.J.B. HILLIARD, W.L. LYONS, LLC7325.05%8.61%1.23%
AMERIPRISE FINANCIAL SERVICES, INC.139525.01%10.55%1.02%
FSC SECURITIES CORPORATION15034.92%10.78%1.60%
TRIAD ADVISORS, INC.8384.89%10.38%2.74%
STEPHENS INC.6594.86%8.35%0.15%
VALMARK SECURITIES, INC.4554.84%7.69%0.22%
IFC HOLDINGS, INC.14964.68%10.56%2.01%
H. BECK, INC.7934.67%12.99%5.42%
CAMBRIDGE INVESTMENT RESEARCH, INC.35384.58%10.15%2.12%
CADARET, GRANT & CO., INC.9124.50%11.29%2.63%
NFP ADVISOR SERVICES, LLC19174.49%9.70%2.19%
BB&T SECURITIES, LLC7644.45%8.12%1.70%
AMERITAS INVESTMENT CORP14634.37%9.64%1.57%
SUNTRUST INVESTMENT SERVICES, INC.15104.37%10.86%1.92%
LPL FINANCIAL LLC183154.35%9.12%1.21%
LINCOLN FINANCIAL SECURITIES CORPORATION11744.26%8.69%1.19%
SANTANDER SECURITIES LLC7254.14%9.79%3.03%
COMMONWEALTH EQUITY SERVICES, INC.27804.03%7.88%1.01%
SECURITIES SERVICE NETWORK, INC.4773.98%9.64%1.26%
EQUITY SERVICES, INC.5983.68%10.03%2.34%
AXA ADVISORS, LLC54743.64%8.88%0.31%
ROBERT W. BAIRD & CO. INCORPORATED24293.58%5.97%0.58%
BMO HARRIS FINANCIAL ADVISORS, INC4773.56%7.97%1.05%
INVESTMENT CENTERS OF AMERICA, INC.6183.56%6.80%0.81%
CETERA ADVISOR NETWORKS LLC31453.47%7.19%1.08%
VOYA FINANCIAL ADVISORS, INC.28063.28%8.27%0.86%
WOODBURY FINANCIAL SERVICES, INC.14793.25%10.89%1.28%
SIGNATOR INVESTORS, INC.16513.15%8.60%1.51%
THE LEADERS GROUP, INC.6733.12%8.02%2.23%
HORNOR, TOWNSEND & KENT, INC.11943.10%7.79%1.34%
METLIFE SECURITIES INC.72333.08%7.88%0.68%
LINCOLN FINANCIAL ADVISORS CORPORATION24363.04%7.06%0.94%
MONEY CONCEPTS CAPITAL CORP5273.04%9.30%1.71%
PLANMEMBER SECURITIES CORPORATION5722.97%11.19%2.10%
CUNA BROKERAGE SERVICES, INC.7852.93%7.64%0.38%
ONEAMERICA SECURITIES, INC.8792.84%8.42%2.50%
INFINEX INVESTMENTS, INC.6092.79%8.37%1.15%
NYLIFE SECURITIES LLC83522.74%8.14%0.41%
1ST GLOBAL CAPITAL CORP.10342.71%5.13%0.29%
THE O.N. EQUITY SALES COMPANY9442.65%8.69%2.54%
PROEQUITIES INC15142.64%7.99%0.92%
BANCWEST INVESTMENT SERVICES, INC.4222.61%6.40%0.95%
PARK AVENUE SECURITIES LLC28412.60%7.81%1.51%
PRUCO SECURITIES, LLC52032.59%7.75%0.37%
FIFTH THIRD SECURITIES, INC.15302.55%6.54%1.70%
KEY INVESTMENT SERVICES LLC11512.43%6.26%2.17%
M HOLDINGS SECURITIES, INC.9222.39%6.29%0.65%
SECURIAN FINANCIAL SERVICES, INC.16432.37%7.12%0.24%
CUSO FINANCIAL SERVICES, L.P.6892.32%7.69%1.60%
MML INVESTORS SERVICES, LLC54092.29%8.78%2.03%
CETERA INVESTMENT SERVICES LLC19262.28%6.44%1.04%
GWN SECURITIES INC.6602.27%9.55%1.67%
WADDELL & REED, INC.28592.24%7.73%1.01%
FIRST REPUBLIC SECURITIES COMPANY, LLC5482.19%4.01%0.55%
CHARLES SCHWAB & CO., INC.76162.14%5.28%0.13%
TRANSAMERICA FINANCIAL ADVISORS, INC.49432.02%6.64%0.79%
PRINCOR FINANCIAL SERVICES CORPORATION36541.94%6.95%0.79%
U.S. BANCORP INVESTMENTS, INC.17371.90%5.76%1.21%
BB&T INVESTMENT SERVICES, INC.7531.86%4.52%0.27%
LINCOLN INVESTMENT PLANNING, LLC11301.86%6.90%0.80%

We also include the measure of these firms using Egan, Matvos and Seru's more expansive definition and the ranking by the percentage of brokers employed at each firm that had previously been fired by another firm after customer allegations. You can sort the list of 100 firm on any of these three measures by clicking on the title at the top of each column.

The 10 highest risk firms with more than 400 brokers include the same 10 firms whether using the FINRA study definition or the broader financial misconduct measure. These 10 firms - especially the six worst firms Aegis Capital, Summit Brokerage Services, National Securities, Centaurus Financial, Independent Financial Group and Kovack Securities - employ a far higher percentage of bad brokers than other firms. 7.71% of the registered brokers in these six high risk firms have been fired at least once by a previous employer after allegations of misconduct, 10 times the average of 0.78% of the remaining 204 brokerage firms. Given their coworkers' disclosure records as of 2014, 83.7% of the brokers at these six firms would be in the highest risk quintile as defined in the FINRA study and should be avoided by investors. The BrokerCheck reports for most of the brokers at these six firms should prominently display a skull and crossbones warning.



Friday, April 22, 2016

How Widespread and Predictable is Stock Broker Misconduct?

In this paper we reconcile widely diverging recent estimates of broker misconduct. Qureshi and Sokobin report that 1.3% of current and past brokers are associated with awards or settlements in excess of a threshold amount. Egan, Matvos, and Seru find that 7.8% of current and former brokers have financial misconduct disclosures including customer complaints, awards, and settlements.

You can download the research paper here.

We replicate and extend the analysis of broker misconduct in these studies. Qureshi and Sokobin arrive at their low estimate by excluding 85% of all brokers, including those brokers most likely to have engaged in misconduct. Applying Qureshi and Sokobin's restrictive definition of potential misconduct to all brokers, we find that misconduct is much more widespread.

We also evaluate Qureshi and Sokobin's claim that its BrokerCheck website provides helpful information to investors seeking to avoid bad brokers and answer the question posed by Egan, Matvos, and Seru: If BrokerCheck data can identify broker misconduct, why don't investors use that data to protect themselves? We find that BrokerCheck is worthless in its current hobbled form, but that it could easily be modified so that market forces might substantially reduce broker misconduct.