Bond Arbitration Cases Boom; More Cases Expected as Interest Rates Rise

By Sara Hansard, Investment News

Arbitration cases against advisers and brokerage firms involving bond sales increased sharply in 2003 as some advisers felt the repercussions of pushing bonds as ''safe and secure'' during the recent market slump.

NASD statistics show that arbitration cases involving corporate bonds jumped 40% to 353 cases in 2003, up from 253 cases in 2002. That was the highest percentage increase for all security types involved in arbitration cases, including mutual funds, which rose 37%, and common stock, which rose 24%.

Total new complaints increased 16%.

Plaintiffs' attorneys predict still more bond-related cases this year.

''More and more such cases will be coming up as interest rates go up,'' said Kirk Smith, a partner with Shepherd Smith Edwards & Kantas LTD LLP in Houston.

''Two to three years ago, financial planners and brokers started pitching
bonds and bond mutual funds with the argument that you need something safe and secure,'' said Andrew Stoltmann, a partner in the Chicago office of Maddox Hargett & Caruso PC, which is based in Fishers, Ind.

''What the brokers didn't tell them was that bonds can lose value, bonds can default,'' he said. ''Investors can lose a tremendous amount in bonds almost as easily as they can in stocks.''

Mr. Stoltmann is representing Russell and Patricia Klucker of Walkerton, Ind., in an arbitration case filed last October against Morgan Stanley DW Inc. of New York and Morgan Stanley financial adviser Mark Scharff, who works in the company's Little Rock, Ark., branch office.

The arbitration claim alleges that the Kluckers lost more than $260,000, including losses of nearly $97,000 in bonds, largely from active trading of mutual fund B shares and bond switching. Mr. Klucker, who was 61 when the complaint was filed last October, had invested nearly $700,000 from his 401(k) in October 1999 with Morgan Stanley. In June 2003, after losses and withdrawals to live on, the value of the account was about $216,000, according to the arbitration papers.

Disclosure lacking

The Kluckers have since closed the account with Morgan Stanley, Mr. Stoltmann said, and Mr. Klucker has had to end his retirement. As a result of his losses, he has had to return to work in a factory. Bruce Lewitas, a Chicago securities attorney representing Morgan Stanley in the case, would not comment, nor would Mr. Scharff.

Advisers who sell bonds to their clients say a major problem with bond sales is lack of disclosure of markups from the brokerage firms and dealers that sell them.

''Most bonds are traded in the over-the-counter market,'' notes Michael Joyce, chairman of the National Association of Personal Financial Advisors in Arlington Heights, Ill. ''Most people can not open up The Wall Street Journal and see what their metropolitan-area sewer revenue bond cost.'' The same holds true for corporate bonds, he added.

Many times, there are two markups, said Mr. Joyce, who sells bonds in his practice, Michael Joyce & Associates PC in Richmond, Va. The brokerage firm that initially sells the bond to other brokers gets a markup, as does the broker who sells it to investors. Further, he added, markups tend to be higher for riskier bonds, or bonds that are falling in value, that brokers want to move out of inventory.

''It's like a car dealership,'' Mr. Joyce said. ''If they want to move something, they'll have a bigger markup on it because that provides a greater incentive for the broker to sell the bond.''

Most investors, he said, are ''blissfully ignorant'' about the incentives brokers have to sell risky bonds.

Interest rates have been low recently. But, said Mr. Joyce, ''I suspect that when interest rates rise again, we've seen just the tip of the iceberg in terms of these arbitration cases.''

Darren Blum, an attorney with Blum Silver & Schwartz LLP in Fort Lauderdale, Fla., said his firm has seen a ''huge increase'' in bond arbitration cases recently. He said his cases involve many high-yield, or ''junk,'' bonds, and many bond mutual funds.

''People were told that the bond mutual funds were safe and secure investments,'' Mr. Blum said. ''They were told that the bond funds are similar to a bond, except you don't have to wait 30 years until maturity; you can sell at any time.''

''What they didn't tell the clients was that they were going to be hit with charges, some as high as 5%, to get out of the mutual fund because they are sold B shares,'' he added.

Mr. Blum said brokers who sold bond funds also did not tell investors that the value of the funds would drop when interest rates go up, which is expected to happen later this year.

Sharon Luker, a financial planner in the Plano, Texas, office of VSR Financial Services Inc. of Overland Park, Kan., believes that part of the problem comes from trying to use bonds for short-term investments. ''If you're pricing your portfolio and charging the client on a percentage of the market value, it starts becoming important if that market value goes down if rates rise,'' she said.

Ms. Luker said her philosophy is to hold bonds until maturity. ''If you hold until maturity, you don't care what the price does,'' she said. But, Ms. Luker added, ''I know I'm one of the oddballs in this.''

Investors have also been confused by industry jargon.

''We've seen people buy bonds which were deemed high yield,'' said Joseph Meyer, president of Meyer & Associates in Ormond Beach, Fla. Mr. Meyer is an arbitrator and mediator with NASD and the New York Stock Exchange. ''What they didn't realize is another word for 'high yield' is 'junk bonds,''' he said. ''They're misled as to the underlying quality of the portfolio that they're buying.''

Many brokers today are not trained well to handle bonds, said Timothy O'Connor, a shareholder with law firm Ainsworth Sullivan Tracy Knauf Warner & Ruslander PC in Albany, N.Y. ''A lot of brokers are trying to be a hero, putting people in high-yield bonds,'' he said. Twenty years ago, Mr. O'Connor added, brokers typically were trained to handle bonds as well as stocks.

''I'm seeing brokers with no experience in bonds thinking that they're going to afford safety to people fleeing the volatility of the stock markets of 2000-2001, only to see further losses'' in bonds, he said.

Not only have many brokers not done due diligence before they sell bonds, Mr. O'Connor said, but they also fail to track them after they make the sale.

He predicts that regulators will eventually focus on requiring more disclosure of bond markups and commissions, as they have done for mutual fund and stock transactions. ''Bonds are the last refuge of scoundrels in terms of hidden commissions and hidden markups,'' Mr. O'Connor said. According to him, bonds are ''the last frontier.''

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