by Bill Singer
Stock to Cash Program Crashes And Burns
October 31, 2011
On December 21, 2010, the Financial Industry Regulatory Authority's ("FINRA's") Department of Enforcement filed a disciplinary Complaint against Raymond Blunk; and thereafter, on October 18, 2011, without admitting or denying the allegations in the Complaint, Blunk submitted an Offer of Settlement, which the self-regulatory organization accepted. FINRA Department Of Enforcement, Complainant, v. Raymond Blunk, Respondent (Order Accepting Offer Of Settlement, Disciplinary Proceeding No. 2007008935009, October 21, 2011).
Background
Blunk, who has held Series 6, 7, 63, and 65 registrations, entered the securities industry in 1989, and during the relevant period, was registered in 2002 with InterSecurities, Inc. (now Transamerica Financial Advisors, Inc.) , working out of Carmel, Indiana. He conducts business through Total Financial Group, which offers various financial services, including retirement financial, estate, insurance, and long-term care planning.
Stock To Cash
FINRA's Complaint alleged that between February 2004 and March 2007, in response to Blunk's recommendation, several of his customers obtained nine purported non-recourse loans worth about $1.8 million from a non-broker dealer through a "Stock to Cash" program that involved the customers' pledging stock as collateral. The loans, with terms of two to five years, resulted in proceeds that the customers used to purchase insurance products through Blunk. In connection with the Stock to Cash program, Blunk allegedly represented:
- the pledged stock would be transferred to the lender's securities account, which was maintained at a clearing firm;
- typically for three years or less, the loans were in amounts up to 90% of the value of the pledged stock;
- no payments were required during the term of the loan; and
- customers were required to pay the full principal and interest due only at the end of the loan term.
Apparently, once enrolled in the Stock to Cash program, Blunk's customers received 90% of the value of their stock and did not pay any interest (unless they sought to recover stock they had pledged). The customers believed that their potential out-of-pocket loss would be limited to 10% of the value of the pledged stock. Additionally, the lending entity purportedly created documentation confirming that it had retained the customers' pledged securities as collateral for a hedging strategy whereby cash was generated through options transactions. At the end of the loan term, customers supposedly had four options:
- the customer could renew the loan for an additional time period;
- the customer could pay the total amount due on the loan and reclaim the stock that had been pledged;
- if the value of the pledged stock had increased above the total amount due on the loan, the customer could elect to receive a cash payment equal to this profit (i.e., the current value of the stock, minus the total amount due on the loan); or
- if the total amount due on the loan exceeded the value of the pledged stock, the customer could walk away from the transaction, keep the money that had been loaned, and forfeit any further interest in the pledged stock.
Not Really A Loan
Notwithstanding the various representations, the pledging of stock by the customers actually conveyed full ownership of their stock to the lending entity conducting the Stock to Cash program - in fact, upon receipt of the securities, the lender routinely sold the securities and often transferred the proceeds into its own bank account.
SIDE BAR: Consequently, the customers weren't so much lending their shares as collateral as they were transferring ownership to the supposed lender, which then sold the securities. Such transactions often have unintended tax consequences and should not properly be marketed as "loans."
Bad to Worse
Although the lending entity's ability to perform its contractual obligations under the Stock to Cash program was largely dependent on the success of supposed hedging strategies, it was not always performing such activities. Unfortunately, by Spring 2008, the lending entity was unable to undertake payments to customers with profitable portfolios, and essentially resorted to a Ponzi scheme in which money from new customers was used to pay obligations to existing customers. Further, the lender diverted funds earmarked for expenses to non-operational needs. In early 2009, the lending entity ceased all payments to customers and its lending ended in Spring 2009.
Undue Diligence
FINRA alleged that Blunk did not undertake adequate due diligence in familiarizing himself with the nature and operations of the Stock to Cash program, and, wrongly relied on information provided by individuals marketing the program. Pointedly, FINRA alleged that Blunk mistakenly assumed that the lending entity was a broker-dealer that held his customers' stock in custodial accounts. FINRA charged that Blunk was obligated to:
have a reasonable basis for recommending that his customers pledge their stock to this lender to participate in the Stock to Cash program. A broker must understand the potential risks and rewards, as well as ensure that the customer understands the risks. In order to do so, the broker must obtain adequate information about the product or investment, and cannot rely solely on the unexamined representations of those promoting it. There is a particularly high need for substantial due diligence in dealing with unregistered and unregulated entities and products, such as the Stock to Cash program Blunk recommended to his clients. . .
Sanctions
FINRA alleged that Blunk violated NASD Conduct Rules 2310 and 2110 (now FINRA Rule 2010), and in response to his Offer of Settlement, suspended him for 25 calendar days and fined him $15,000.