Fraudbuster John Lawrence Allen

How did you end up defending investors? I had always been interested in investing in stocks, even in high school. I invested all through college, all through law school, and then began trading bonds, gold, and currency.

And after you passed the bar? I started my law career as a prosecutor in the Los Angeles district attorney's office. After leaving the DA's office, I went into private practice, and in 1980 I invented a stock arbitrage trading program. Right around then the Standard & Poor's 500 index came out, and I thought that was great. I didn't have to pick a manager. I didn't have to decide where earnings were going. I didn't have to worry about what company to buy. I could buy the overall market. I thought that was the way to go. At that point I got interested in trading futures: I thought it was a fascinating world.

What did you do? I formed my own company and traded my program successfully for several years. I had a program up and running, with a live feed from the Chicago Mercantile Exchange and a real-time computer-generated trading program, on the first day the S&P started trading. I was ahead of the curve.

And? The world caught up with me. Once the markets caught up with me, my competitive edge was gone. That's why I did so well the first two years, until the brokerage companies figured out how the S&P traded, how it worked, and what the relationships were. Eventually, the market became very efficient. If I had known then what I know now, I would not have been trading one and two lots. I would have been doing 10 and 20 lots. And I would have retired!

Is that when you decided to become an advocate for other investors? No, I remained in the securities business for six or seven years, working for what was then Shearson Lehman/American Express, and then in 1989-90 I went back to practicing law. Since I had been trading and managing money for a number of years, that's when I went into the area of law that specializes in stockbroker and securities fraud. I wanted to help people get their money back.

What did you see in the securities industry that made you want so strongly to be on the investor's side of the equation? I grew disenchanted with what I saw as the sales practices in the securities industry. It seemed as though the focus of the industry was in providing income — commissions, fees, monies — to the brokerage companies, without concern for how the investing public or the clients were doing. Basically, I grew disenchanted with the sales practices. That's when I decided to help investors not be the victims of the brokerage companies.

Is part of your concern that brokerages are going out of business and taking their clients' money with them? I think that has already happened. You can see the magnitude of the consolidation in the brokerage industry. As each year goes by there are fewer and fewer brokerage companies around because of the mergers and acquisitions. And some brokerages just don't stay in business, simply because they are not doing an adequate job.

Are only the small companies a reason for concern, or could some of the major players have problems as well? My concern is for investors. When you as an investor open a brokerage account, you expect to get fair and adequate advice, and further, that such advice will not be self-serving to the brokerage. It should be advice in the best interests of the client, rather than in the best interests of the brokerage firm. There is an inherent conflict every time you speak to a broker or a brokerage company, between providing the best advice for the client and providing the highest commission charge for the company. The investor should get the highest dollar value for whatever trade they are going to execute, or whatever product the brokerage is going to recommend. Generally speaking, when you get to the lower-tier firms you tend to find more abusive practices. This could be because compliance isn't there or because supervision is lax.

Are there other reasons as well? A less obvious problem is that when the major companies, or more prestigious companies, let an employee go because he or she has been a problem broker, where do you think the broker will go? Probably to a lower-tier firm. I can't make a blanket statement, but generally, you're going to have more problem brokers and less supervision in those firms.

Then, of course, you have the issue of capital. As you get to smaller and smaller firms, the capital requirements are less and less. If those firms are responsible for a major loss, and should you sue them, they might not be able to pay you. I have had plenty of cases where we have either had to settle for less than the client was entitled to because we would put the firm out of business otherwise, or we have had to structure a settlement over time because they did not have the money to pay the settlement in one lump sum.

Is there any common abusive practice in particular you would like to mention? Let's talk about what is going on right now on the stock and option side. I have seen quite an increase in churning cases. That may have come from the bull market. In that bull market, if a broker was churning a client's account, the strong market hid a lot of their sins. Clients were unable to figure out that their accounts might have been churned while the market was going up. Their brokers were still making money for them, so the clients were not going to pay that much attention to the commissions being charged.

Could you give us an example? If you have $100,000 with a broker, and you make $5,000 for the year, although it is not a lot of money, at least you made money. Then when the market turns down, you go back and look through your statements. You find out in the year you made $5,000 you also paid $25,000 to $30,000 in commissions. That could be and most likely is churning. Because you made money, you never bothered to look at the commissions. That $25,000 to $30,000 your broker made should have been in your pocket, and not his.

You also mentioned options. What's the problem there? I've seen a lot of options strategies blow up. There has been a lot of naked put and naked call writing. With the market having the big selloff it had, I have seen lots of accounts blow up from what people thought were income-generating strategies. The options were put on in such a way they didn't have any risk-limiting mechanism. There was no hedge. There was no portfolio protection. There was no insurance. When you have naked options and the position goes against you, it can be dramatic.

What kind of losses have your clients sustained? I have had some people who were making money for years lose everything they started with, plus everything they had ever made, in a very short period of time.

Besides churning accounts and writing naked puts, are there other scams that investors should be aware of? Another thing I have seen is the high encouragement of short-term trading. The broker will tell clients the market is very volatile, and encourage them not to hold anything for any length of time; instead, they should take quick profits and quick losses. I have a number of clients who had no or limited experience in the market, and the brokers would call them up and tell them: "Take a profit. You've got two points. Take a loss. You've lost three points." They get moved in and out of stocks. As a result, the account has a high turnover ratio, but no profits and dramatic losses.

What about those who are trading online and churning their own accounts? Those who are trading online can continue doing so, as long as they are aware of their risks. But they should remember that the more you trade, the more opportunity you have for making a mistake. In spite of what anybody might tell you, trading is more of an art than it is a science. If it were a science, the engineers would own Wall Street, which they clearly don't.

There is an art to trading. I was an active trader in the most volatile of all markets, the S&P. I was trading futures in the S&P, against the stocks. I was trading not by the day, but by the second. I was trading like a local from the pit, only I was trading from Los Angeles while I was on the phone with my clerks in the Chicago Merc.

That must have been a challenge! I learned after the fact that the more decisions I had to make, the more opportunity I had to be wrong. There was more opportunity for slippage, for errors, for problems, for fast markets, and for poor executions. I formed the opinion — daytraders are not going to like this — that the real money in the market is made by people who take positions, hold them, and ride the trend. By doing a lot of trading, you are just inviting yourself to pay a lot of commission, and you open yourself up to the opportunity to lose a lot of money. Certainly there are people who have that skill, that art, to trade, and do it well. But I will bet you it is fewer than 1%.

You mentioned poor executions. Is that something you saw a lot of? When you are asking a broker who may have his/her own position to make a trade for you, like in the futures market, there is always that possibility they will think of themselves first. There is always the possibility they will use your order as a safety valve for themselves. The broker may either front-run, or trail behind one of your trades, and you might not get the best possible execution. I often wondered why it was that when the market had a break, up or down, and I was trying to get out, more often than not I got filled close to the bottom of the move. When you are trading and suddenly the market falls, you are trying get out. You get filled toward the bottom, and then the market recovers. Why aren't you the one who got filled at the better price?

That's a question we definitely need to have answered! Although brokers are not supposed to take care of their orders before their clients, human nature is such that some will take care of themselves first. This is just one more opportunity for investors to get caught in a gap.

Have you seen what's referred to as "running the stops"? I have. I have been on the phone with my clerk and in the quotes the market is even at 0.05, even at 0.05, even at 0.05. I'll tell my clerk: "There are a lot of stops below even. I see a lot of stops at 0.95, 0.90, and 0.85, but they are telling me their decks are full of stops at 0.85. If the locals are able to push the market below even, we might get a break."

How does it work? The locals, and the people with the decks, are going to know where the stops are and where they are going to look to take them out. If they can buy in at that break, they get a good price. It happens. I can't tell you how many times I've been long and seen the market break. I tell my broker to get me out and get out at the bottom, or within two ticks of the bottom of that move, after which the market turns around and goes right back to where I was.

You said those who buy and hold are going to make more money. You are speaking of holding through the trend, right? Not just taking a buy-and-hold position? If you are a stock investor, the biggest money to be made is always made by people who buy and hold. If you traded Microsoft instead of holding it, you are not going to make a fraction of what you would have made. I have a friend who is on the floor of the Merc. He was my clerk back in 1980, and he's still trading. I remember talking to him at the beginning of the 1990s bull market. He would have been better off if he had held stocks instead of continuing to trade, but traders have it in their blood. They want to trade. I've been there and done it.

Getting into trades is the easy part. But you should never get in if you don't know when to get out. So how do you know when to get out?

Continued in Part II

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