Spotting broker red flags

By Larry Schneider

In the world of futures trading, speculators know what they’re getting into as soon as a trade is entered. Go short cattle on strong supply numbers, then a mad cow scare hits, causing multiple limit up moves. Doesn’t matter the scenario, trading involves risk.

But traders never should have to be concerned that their money on deposit with regulated entities might be in jeopardy. Unfortunately, the collapses of MF Global and Peregrine Financial Group (PFG) have caused futures traders to grapple with hijacked segregated funds. Speculators and hedgers alike need not only a trading plan to manage market risk, but also a plan to spot brokerage firm risk.

The Wall Street Journal recently ran an article titled: “True or false: Many Americans don’t understand the basics of investing.” While the majority of futures traders have a higher level of investment literacy than typical retail investors, these same traders — who understand leverage, complex economic analysis and moving average crossovers — have very little knowledge about the realities of segregated funds balances, open trade equity protections and the daisy chain movement of client funds.

To spot broker red flags, you first need to understand better where your money is and just who has it (see “Follow the bouncing money”).


Based on our schematic, where is Trader Bob’s money?

When Trader Bob discussed opening an account with the introducing broker (IB) Todd LLC, he should have asked these important questions:

  1. Is your IB relationship with a clearing or non-clearing futures commission merchant (FCM)?
  2. If it is with a clearing FCM, which clearinghouse(s) does the FCM belong to?
  3. If it is with a non-clearing FCM, who actually is clearing those trades?

Who is the clearing FCM (or FCMs) that actually holds Trader Bob’s margin funds when he holds a position?

And because broker omnibus relationships can change all the time without notification made to the client, these questions need to be asked on a regular basis.

Returning to the fictional brokerage firms in the illustration, it is not enough to be told that Larry Co. is a member of a particular futures exchange. The question you want answered is whether or not Larry Co. is a clearing member of a particular exchange.

Now that you have a better understanding of what firm actually is responsible for your seg funds balance, you can begin your own red flag watch.

Due diligence

The first step should be a visit to the National Futures Association’s (NFA) BASIC web page. BASIC stands for Background Affiliation Status Information Center. BASIC is free and available to the public without needing to register or having a password. Searching by firm name or individual name, you can view Commodity Futures Trading Commission (CFTC) registration and NFA membership information and futures-related regulatory and non-regulatory actions contributed by various regulatory agencies and futures exchanges. Without giving you the name of one particular FCM searched, I found 11 separate regulatory actions and 167 CFTC reparations cases, including a $75,000 fine for recordkeeping practices. Smoke does not mean fire, but you cannot have fire without smoke.

At the very least, BASIC will let you know if your brokerage firm, commodity trading advisor (CTA) or commodity pool operator (CPO) is registered with the NFA. We read weekly about criminal charges brought by the CFTC against unregistered, unlicensed CTAs, CPOs and retail forex dealers. If someone solicits your account for trading futures or currencies, in any manner of investment vehicle, and the broker and his or her firm is not found on BASIC (or FINRA’s Broker Check), it is best not to proceed.

There are many excellent, well-regulated and well-run investment pools, funds and partnerships, but not all of them are above reproach. In addition to the usual questions you should ask regarding performance, drawdowns and trading strategy, be sure to ask the name of the brokerage firm where the investment is housed and which will be clearing the trades. The first red flag would be when the investment manager refuses to provide the information. The second red flag could be when the investment manager gives you a name of a broker or auditor or anyone else you can call to confirm a legitimate account. Instead, call the brokerage firm directly (you can find contact info on BASIC). If the manager offers individually managed accounts, it is up to you to choose a broker. While he may provide a list of approved FCMs, he should not be steering you to a specific broker, particularly if its commissions are non-competitive.

Multiple levels of checks are better, so it is best to perform due diligence on a broker and manger separately. If you are getting information from only one source on an IB, FCM and manager, you are not doing effective due diligence.

Publicly traded companies like MF Global have numerous reports they must file with the Securities and Exchange Commission (SEC), and, as a registered FCM, MF Global had to submit monthly segregated account reports to the CFTC. These reports can reveal a lot of information, though many of them, especially SEC filings, can be dense and hard to interpret if you don’t know what to look for. Find someone who does.

The CFTC numbers are more straightforward. They list the amount of customer segregated funds the FCM holds as well as adjusted net capital, net capital requirement and excess capital. Large swings in any of these numbers, particularly customer funds, as MF Global experienced, are one red flag. A more serious flag is a shortfall in the excess net capital. MF Global’s July 2011 report showed it negative $150 million after being forced to adjust this number by regulators. The total seg funds reported by MF Global in July was $8.8 billion; that dropped to $7.3 billion in August (a volatile month that would have required higher margins) so someone was paying attention.

A red flag that has come up in several cases is inadequate auditing. A large futures broker or investment firm should have, if not one of the big four, an institutional level auditor. The Sam Israel Bayou Hedge Fund, Bernie Madoff and PFG scandals all used sole proprietor or inadequate auditors. While the big guys have messed up as well, a large firm managing hundreds of millions of dollars shouldn’t be hiring someone working out of his (or her) garage. If they do, it is a blazing red flag.

Anecdotal red flags

Another red flag perhaps should focus not on the brokerage firm, but on introspection. Boston University Professor Tamar Frankel has studied hundreds of frauds and schemes. Her research has concentrated not just on the scheme and schemer, but also on the gullibility of the victims. She says, “Many con artists make it seem that they are limiting access to their investments, making them available only to a select few. Now, rationally, why would a money manager do that?”

Good question, but Madoff, in particular, used this approach.

We now know that balance sheet and bank balance fraud can be hidden from the self-regulatory organizations (SROs). So with the benefit of hindsight, perhaps we need to be on the watch for grandiose actions of the CEO or chairman. New expensive headquarters can be a red flag as well, particularly when they can’t be justified by growth in business and or profits, as was the case with PFG’s fancy green Iowa headquarters. This bit of conventional wisdom extends to the castles the CEO may be building in his or her mind. Jon Corzine seemed set on recreating Goldman Sachs at MF Global and publicized those plans widely, including here in Futures.

Some internet-sleuthing on PFG’s Russell Wasendorf Sr. would have revealed his firm defaulted on the terms of state loans used to build PFG’s new $18 million headquarters in Cedar Falls. Here was a man who owned a private jet, opened restaurants and engaged in activities to portray himself as a grand philanthropist, yet couldn’t pay his rent.

A web search on Corzine would have revealed a man whose ego and hubris were perhaps a bit too over the top.

Bernie Madoff was a quiet man but he was the exception. SEC and CFTC records are filled with investment advisors who seemingly came up from nowhere, suddenly driving the most expensive cars, buying the most expensive homes and contributing the most to high society charity events. Eventually their Ponzi schemes fall apart and their wealth is discovered to come, not from trading, but from the funds handed over to them by unsuspecting investors. A lavish and flashy lifestyle can be another subjective red flag. If a Google search of your advisor comes up with more hits on society pages than financial articles, it should raise suspicion. A hubris test could be used as a subjective counterbalance to more traditional financial ratio tests.

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