The Small Brokerage Firm

I have previously cautioned investors about investing at small brokerage firms. Small and dubious brokerage firms come and go relatively quickly. If you have a problem, you may find yourself with a monetary judgment but no entity from whom to collect it. At one time, I represented almost 100 investors in arbitration claims against a firm called Dickinson & Company. Dickinson had offices and brokers all over the country, however, within a year or so of the filing of my cases, Dickinson closed its doors and ceased doing business in the securities industry. My clients’ only hope for recovery is against the individual managers and President of the firm who I named in the action (see May, 1997 article entitled "Board of Directors Beware").

Many people are surprised to learn that brokerage firms do not have insurance. I like to say that it is because the brokerage industry is likened to a roller coaster - the insurance companies know that the smallest problem can lead to big monetary claims, so they refuse to insure them. In that sense, small brokerage firms are no different than bigger firms. However, the larger firms are able to pay investor’s claims and stay in business. Keep that in mind, too, when dealing with a small brokerage firm.

Investors are sometimes lulled into a false sense of security when dealing with a small firm, because of the name recognition of the clearing firm. A clearing firm is a brokerage firm that processes trades for another firm. For example, Bear Stearns acts as a clearing firm for numerous smaller, little-known brokerage firms. Your brokerage firm may tout the clearing firm, riding on the coattails of its recognition. The Customer Agreement that you sign most likely will be with the big-name clearing firm, as opposed to the brokerage firm (assuming your brokerage firm clears through another firm). The trade confirmations and monthly statements you receive may be emblazoned with the well-respected clearing firm name. Therefore, you may feel that your money is in safe hands and that the big firm, like a big brother, will somehow protect you. Not.

The Clearing Business

Last year, Forbes wrote an article about Bear Stearns and its clearing business. It told the story of a man who was pleased when his broker informed him that he was moving to a new brokerage firm - A.R. Baron & Company and that Bear Stearns would be clearing the trades. The man later said, "I felt we were in excellent hands…Bear, Stearns was a household name." Almost immediately after the move, the man began to get confirmations for trades he never authorized. He promptly complained and, after receiving no help from A.R. Baron or his broker, he turned to Bear Stearns for assistance in reversing the trades. Bear Stearns’ response? "We are just the clearing firm…we can’t help you." In fact, the written agreements between clearing firms and introducing brokers typically cleanse the clearing firm of responsibility for virtually all wrongdoing that can occur in the handling of an account. Case law follows suit, rarely finding clearing firms liable for the misdeeds of brokers whose trades they process.

Don’t take comfort in the fact that your small brokerage firm clears through a big one. And don’t think that your small brokerage firm must be on the up-and-up or else the big firm would not associate with it. The Forbes article accused Bear Stearns of sleaziness in getting cozy with numerous discredited bucket shops, like A.R. Baron. A.R. Baron subsequently filed bankruptcy and its principals were indicted for stealing more than $75 million from investors - quite an embarrassment for Bear Stearns. Another sleazy firm, Sterling Foster, cleared through Bear Stearns. Sterling Foster was a penny-stock firm that the NASD sued for $53 million in a fraud case. Again, no liability for Bear Stearns.

The Tit for Tat

Where’s the tit for tat? For small firms, particularly bucket shops, having Bear Stears or a recognizable name as a clearing firm gives them a certain cachet. They can lure in more clients with the facade of respectability. More importantly, for many smaller, under capitalized firms, the clearing firm is their lifeline. A clearing firm will pony up significant capital to a brokerage firm, allowing the firm to do business on a relatively small deposit, usually a minimum of $250,000. Without the clearing firm help, many of these firms would not get off the ground or survive. In fact, the man I mentioned above who got no help from Bear Stearns regarding his unauthorized trades - he’s currently suing Bear Stearns, claiming that in keeping Baron alive for almost a year, Bear, Stearns enabled the firm to harm investors with its fraudulent sales practices.

For the clearing firm, money is also the name of that game. The clearing firm gets to use the introducing broker's deposit interest-free. For every transaction executed by the brokerage firm, the clearing firm reaps a "ticket charge" - of anywhere from $10 to $30 per trade. The clearing firm also charges interest—typically 1% a month—of customer debit balances carried on the clearing firm's books. The interest meter starts ticking the day a trade is done. This is where the real money in clearing is made. Clearing also have free use of customers' credit balances.

The clearing business is extremely lucrative. Bear Stearns clears for more than 200 brokerage firms and gets 25% of its profits from clearing for other firms. A Bear Stearns company spokesperson once said, "Clearing is a very, very proprietary business for us, and we don't want the public knowing about it." Sorry, Bear Stearns - I think the public has a right to know how their trades are being handled.

Tracy Pride Stoneman is an attorney specializing in investment related complaints. Email her at Tracy@InvestorFraud.com. Preparation of this article was assisted by Douglas J. Schulz, a registered investment advisor and former stockbroker in Colorado Springs.