FINRA AWC Cites Dubious Options Strategy In IRA Account

January 31, 2020

In today's featured FINRA regulatory settlement, we come across an elderly, retired customer who was victimized by unsuitable options trading. As bad as the facts are, when you parse through the numbers, it's not as outrageous as you first think. Be that as it may, when choosing between the lesser of two evils, it's important to consider that the choice is still between two evils.

Case in Point

For the purpose of proposing a settlement of rule violations alleged by the Financial Industry Regulatory Authority ("FINRA"), without admitting or denying the findings, prior to a regulatory hearing, and without an adjudication of any issue, Mason Gann submitted a Letter of Acceptance, Waiver and Consent ("AWC"), which FINRA accepted. In the Matter of Mason Gann, Respondent (FINRA AWC 2018057425201)

The AWC alleges that Gann was first registered in 1999, and by June 2012,  he was registered with FINRA member firm Berthel Fisher & Company Financial Services. The AWC asserts under "Relevant Disciplinary History" that:

In March 2018, Gann entered into an AWC with FINRA in which he consented to findings that he exercised discretion without written authorization in six customers' accounts, thereby violating NASD Conduct Rule 2510(b) and FINRA Rule 2010. For that violation, Gann received a 20-business-day suspension and $5,000 fine.

71-Year-Old Retiree Customer JM

The AWC alleges in part that:

JM opened an IRA at Berthel Fisher in 2012, after having previously been Gann's customer for several years at a different broker-dealer. At the time, JM was 71 years old, married, and retired, and his account value was approximately $205,000. Since retiring in 2009, JM had taken $1,500 monthly withdrawals from his IRA to pay for current expenses. He had also occasionally withdrawn larger amounts to pay other expenses. JM informed Gann that he intended to continue withdrawing $1,500 on a monthly basis indefinitely. 

Between 2013 and 2015, JM's account holdings did not produce enough income or gains to offset his withdrawals, and by August 2015, the value of JM's account had declined to approximately $120,000. On an annual basis, JM's withdrawals equated to 15% or more of the account value by that point. Thus, continuing withdrawals at the same level was likely unsustainable for the long term, and Gann exacerbated the problem by recommending that JM begin trading options, which Gann conceived of as a way to generate more income in the account. At the time, JM's only other source of income was Social Security benefits. His IRA represented essentially his entire liquid net worth, and he had little or no experience trading options. Nonetheless, JM followed Gann's recommendation. 

Between August 2015 and January 2018, JM wrote 20 covered call options, purchased 22 put and call options, and wrote six uncovered put options, all based on Gann's recommendations. Because of the risk inherent in both buying puts and calls and in writing uncovered puts, those recommendations and resulting transactions were unsuitable for JM, given his investment profile. 

Under $20,000

The AWC alleges that although it was Gann's practice to sell the options at a profit before expiration, four of the 22 options purchased for JM between August 2015, and January 2018 expired worthless. Pointedly, one Call that was acquired for $11,538 (at a time when JM's account balance was down to about $72,000) expired worthless and caused about a 15% diminution in the overall account's value. Perhaps out of sense of desperation, Gann then resorted to sales of six uncovered Puts, which ultimately cost JM's account another $16,923 loss when they were finally sold to close. As noted in the AWC:

Although several of the options contracts Gann recommended to JM were profitable, JM lost more than $12,500 as a direct result of the unsuitable options strategy that Gann recommended to him and effected on his behalf. By January 2018, the combined effect of investment losses and steady withdrawals had reduced JM's account balance to below $20,000. 

FINRA Sanctions

In accordance with the terms of the AWC, FINRA charged Gann with violations of FINRA Rules 2111 and 2010; and the self-regulator imposed upon him a three-month suspension from associating with any FINRA broker-dealer in any capacity. In response to Gann's submission of a sworn financial statement and his demonstration of his inability to pay, FINRA declined to impose any monetary sanctions.

Bill Singer's Comment

Note that although JM's Individual Retirement Account ("IRA") was first opened with Gann at Berthel Fisher in 2012, JM had "been Gann's customer for several years at a different broker-dealer." As such, Gann should have been familiar with JM's background -- particularly the part about JM having retired in 2009 and his $1,500 monthly withdrawals.

Back in 2012, JM's account started with $205,000; but by 2013, the account wasn't throwing off enough income to cover his monthly $1,500 withdrawals, which by August 2015 had reduced the IRA's value to $120,000. That an important point to stress. In fairness to Gann, when he steps in with his dubious options strategy, JM's account had already lost over 50% of its 2012 value and was down to $120,000. In unfairness to Gann, the AWC makes it clear that in 2012, JM 's "only other source of income was Social Security benefits. His IRA represented essentially his entire liquid net worth, and he had little or no experience trading options. Nonetheless, JM followed Gann's recommendation." To make matters worse, JM's August 2015 balance of $120,000 shrunk to $20,000 by January 2018. 

Somewhat lost in the AWC is a clear-cut explanation of the mechanics that reduced JM's $120,000 balance to $20,000. The AWC concedes that by "January 2018, the combined effect of investment losses and steady withdrawals had reduced JM's account balance to below $20,000." That's an important point because the AWC fails to allocate how much of the $100,000 reduction was parsed between JM's $1,500 in monthly withdrawals versus Gann's failed options strategy. Given that the diminution in value is pegged over a 28 month period (August 2015 to January 2018), we might impute $1,500 X 28 or a total of $42,000 in monthly withdrawals over the relevant period. Consequently, Gann's failed strategy may have cause a further $58,000 in account devaluation.

No . . . I am NOT suggesting that Gann should be given a medal for generating $58,000 in option losses in a retired customer's IRA. When you read the prior sentence, Gann's strategy strikes you as even more dubious. As such, nothing that follows in my comment is intended to justify Gann's options strategy for JM -- pointedly, it strikes me as unsuitable and grotesquely so. 

Ultimately, my problem with the AWC is that is seems to allege that Gann virtually wiped out JM's IRA. A more careful reading of the AWC, however, reveals that such is not a true depiction. Clearly, FINRA is wholly justified in arguing that the AWC says what it says and does NOT imply that Gann did anything other than implement a disastrous options strategy. To that extent, FINRA's position is correct -- on the other hand, the AWC doesn't clearly set the stage with a more forceful presentation of the diminished account value that Gann was working with when he started his unsuitable options trading. 

In reality,  Gann's options strategy seems to have yielded about a $58,000 diminution in JM's account. In contrast, JM's withdrawals generated a nearly $147,000 reduction from the 2012 value of $205,000. Similarly, left to his own preference a la $1,500 monthly withdrawals, JM would have withdrawn the entire $205,000 balance (as of 2012) in 137 months ($205,000 / $1,500 = 137 months) or 11 years, which means the account would likely have zeroed out by 2023. Regardless of all that math, Gann certainly hastened the speed with which JM's account reached zero. Moreover, the AWC makes a compelling case that JM was not well-served by Gann and that the trading at issue was unsuitable for the retired client.