Alternative Investments Begin to Haunt LPL Financial


LPL Financial, the country’s largest independent broker-dealer, is encountering serious problems involving its sales of alternative investments. LPL is also (not coincidentally) one of the country’s largest sellers of alternative investment products. In 2011, LPL sold $758,435,677 of variable annuities (which are considered by most industry observers as being alternative investments) and $110,643,148 of other alternative investments, according to InvestmentNews.

Alternative investments are generally deemed to include investments other than traditional stocks, bonds or mutual funds comprised of stocks and/or bonds.  This very broad category includes structured notes, structured products, hedge funds, private equity funds, nontraded REITs, exchange traded funds, variable annuities, promissory notes, junk bonds, limited partnerships, and various other atypical securities.

While alternative investments cover a wide range of products, they typically share common characteristics that make them problematic for investors.  As a group, alternative investments tend to be illiquid – that is, they cannot be readily liquidated except at a substantial discount or with a substantial penalty.  This makes them unsuitable for investors who may need liquidity – for example, investors who do not have another rainy-day fund to meet expected or unexpected expenses.

Alternative investments are generally complex and lack transparency both in the way they operate and the way they are priced.  They are difficult to value and are often priced using costs, models or guesswork.  This makes them difficult for investors and selling brokers to fully understand, and also renders them subject to valuation fraud.

In addition, alternative investments, as a group, tend to be relatively costly to own and lucrative for brokers to sell.  They are high-commission products, and the high commissions drive sales, even though such products may be unsuitable for the customers to whom they are sold.   This is why it is often said that alternative investments are sold (i.e., pushed) not bought (i.e. demanded).  Regulators are concerned about the sales practices and lack of proper supervision at the firms that sell these products.

A recent example of a problematic alternative investment sold by LPL is nontraded real estate investment trusts (nontraded REITs).  At least one state regulator has charged LPL with serious sales practice and supervision violations in connection with sales of nontraded REITs.

Nontraded REITs are illiquid, high-risk securities that were once only sold to sophisticated investors, but are now routinely sold to ordinary income-oriented customers, often retirees who need to investment income to meet living expenses.  Like many other alternative investments, sales of nontraded REITs have proliferated as investors were lured by promoters promising a safe haven from stock market volatility and amounts of income that cannot be obtained from CDs or money market funds in low interest rate environments.

Nontraded REITs are unlisted and, therefore, are not directly subject to the volatility of the financial markets.  They are, however, illiquid, difficult to value, and subject to valuation shenanigans. They also  have a high degree of risk, and their values have been negatively impacted by plummeting real estate values and the general economic decline.  The distributions paid by nontraded REITs are often not really “income,” but are actually recycled investor capital and borrowed funds.

A number of nontraded REITs have suffered dramatic declines in value and have suspended distributions in recent years.  Despite their evident unsuitability for many retail investors, nontraded REITs have been aggressively marketed and sold to them because they pay commissions in the range of 5% to 7% – far more than a broker could make from selling traditional investments.

Last December, the Massachusetts Securities Division charged LPL with dishonest and unethical practices and failure to supervise its associated persons who sold $28 million in nontraded REITs to nearly 600 clients between 2006 and 2009.  In so doing, LPL allegedly violated the state’s 10% concentration limits and received $1.8 million in commissions for those sales.  In February of 2013, Massachsetts ordered LPL to pay $2 million in restitution to the nontraded REIT investors and pay a $500,000 administrative fine.

As part of the Massachusetts settlement, LPL reportedly agreed to reform its sales and supervisory practices relating to alternative investments.  One of the problems that Massachusetts found was that LPL had stringent requirements “on paper” for the sale of these products, but “[i]n practice, LPL failed to review properly sales of nontraded REITs.  While purporting to conduct a thorough review of offering documents, LPL overlooked prospectus requirements in numerous sales of nontraded REITs” (Massachusetts sues LPL over nontraded REIT sales,” InvestmentNews).

LPL has a history of supervisory and sales practice problems, and has faced increased scrutiny from regulators, which was reported to be among the factors that caused UBS to downgrade LPL’s stock to “sell” last September.   LPL’s CRD discloses 41 regulatory events and 44 arbitrations.  In addition to the Massachusetts action, among the more recent disclosure events are the following:

1) In February of 2013, the Financial Industry Regulatory Authority (FINRA) ordered LPL to pay $1,367,000 to a couple that alleged that LPL committed elder abuse and fraud in connection with the sale of tenant-in-common (TIC) investments – another type of complex and illiquid alternative  investment.  In an apparent attempt to keep information from leaking out to investors, LPL asked the arbitration panel to seal the testimony of the claimants’ eyewitness, but the panel denied that request.

2) At the end of 2012, LPL entered into an Acceptance Waiver and Consent (“AWC”) with FINRA pursuant to which it agreed to pay a $400,000 fine for failing to establish and maintain an adequate supervisory system and written procedures.

3) Also in late 2012, Montana ordered LPL to pay a $10,000 fine and $25,000 in restitution for failing to supervise a registered representative.  The state also required LPL to provide a disclosure document to clients of this registered representative.

4) In late 2011, LPL was fined $250,000 by Illinois for failing to supervise one of its registered representatives.  The fine related to sales of a promissory note – a type of alternative investment.

5) Also in late 2011, LPL was ordered to pay a $400,000 administrative assessment by Pennsylvania for failing to supervise at least two registered representatives.

6) In 2011, LPL was fined $100,000 by Oregon for unsuitable sales of risky oil and gas limited partnerships (another alternative investment) to customers, many of whom were elderly and incapable of making financial decisions.  One of its registered representatives went to prison for recommending a real estate investment trust and then misappropriating hundreds of thousands of dollars of the client’s money, among other things.

7) Again in late 2011, LPL was subjected to a cease and desist order and a civil penalty for failing to diligently supervise the securities activities of one of its branch managers.

In reaction to the Massachusetts suit, LPL is said to be belatedly changing its supervisory and compliance policies and procedures with regard to sales practices involving alternative investments (“LPL beefing up its compliance in wake of Massachusetts suit,” InvestmentNews).  In addition to nontraded REITs, LPL is purportedly changing its oversight of other alternative investments, including leveraged and inverse exchange traded funds, which are listed in the top 10 investor traps by state securities regulators and have been the subject of investor alerts by the SEC, warning of the dangers of such ETFs.

Investor attorney J. Boyd Page of Atlanta-based Page Perry commented:  “If LPL is just now realizing that its supervision and compliance is inadequate, and needs to be changed, investors who have invested through LPL have cause to be concerned.”

Page Perry is an Atlanta-based law firm with over 150 years of collective experience maintaining integrity in the investment markets and protecting investor rights.