Looking the other way while a broker racks up commissions by making excessive trades can have devastating consequences for his or her supervisor: a lifetime ban from the securities industry.
That is the message from the U.S. Securities and Exchange Commission, which recently upheld such a penalty against Carl Birkelbach, the founder of now-defunct Chicago firm Birkelbach Investment Securities Inc.
Birkelbach, now 72, failed to supervise a broker who generated more than $1 million in commissions during 3-1/2 years in the early 2000s while handling an account for Chicago artist Amy Lowry, the SEC wrote in a July 2 opinion.
Birkelbach disputes that figure and says he plans to appeal the decision in federal court.
The case illustrates the conflicts of interest that can arise for a supervisor of an account that is lucrative for both the broker and firm, lawyers say. Lowry's account represented 18 percent of the Birkelbach firm's revenue from late 2002 through 2005, the SEC wrote.
Birkelbach, who worked in the securities industry for more than 30 years, says he properly supervised Lowry's broker, who was also barred from the industry. "I felt as though, in this instance, I had done everything I could for the client," Birkelbach told Reuters.
He says commissions from the account totaled about $250,000, but the firm presented the figures to Lowry, who did not object. The SEC refutes that point.
Brokerage branch office managers commonly receive bonuses based on commissions their brokers earn, said Andrew Stoltmann, a Chicago-based lawyer who represents investors in securities arbitration cases.
"The branch office manager has every incentive in the world to bury his head in the sand and ignore red flags," said Stoltmann, who was not involved in the Birkelbach case.
A trader friend of Lowry's introduced her to the firm in 2001 after she inherited Proctor & Gamble Co stock from her father, according to the SEC. The friend suggested that she use an options strategy known as writing "covered calls" to boost her investment income while holding on to her shares. That would protect her from the large capital gains taxes that would become due on those shares if she sold.
Birkelbach says the trading strategy achieved those goals.
Lowry opened an account at Birkelbach with about 20,000 shares of her P&G stock, worth $1.5 million. A new broker, William Murphy, took over the account a year later, and trading increased dramatically.
Murphy, who did not return a phone call requesting comment, had been previously suspended by the Chicago Board Options Exchange for trading a client's account without permission.
Murphy made about 2,600 options trades in Lowry's account between mid-2002 and early 2006, according to the SEC. It said he had often sold and bought back the same series of option contracts, which boosted his commissions, and sometimes he traded multiple times on the same day.
That frequency is excessive for a covered call strategy, an options trader told Reuters.
The account ultimately had $871,000 in trading losses. At one point, Lowry owed as much as $1.2 million in her margin account.
Lowry signed a new options agreement in 2004, thinking it was because she changed her last name. She later testified that the agreement had been altered to allow more options trading strategies and describe her as having 10 years of investing experience. She says she had no investing experience when she opened the account.
Then examiners from the National Association of Securities Dealers visited her home in 2005 to discuss her account. The regulator, now the Financial Industry Regulatory Authority, discovered the situation during a standard examination of the Birkelbach firm.
Lowry, now 56, closed the account in 2006 and filed an arbitration claim against the firm. She settled for $150,000 after a mediation. "It was emotionally exhausting, and I was paying money out to lawyers," she said.
Birkelbach said he was penalized with a lifetime bar because he "had the nerve" to appeal an initial FINRA order that included a six-month suspension and $25,000 fine. FINRA's appellate body increased the penalty to a lifetime bar.
Birkelbach, in his SEC appeal, said he stopped by Murphy's office regularly to talk about the account. But the SEC said that did not amount to serious scrutiny.
He also sent duplicate statements for Lowry's account to her accountant and a financial planner he had brought in.
Still, the planner - and even the firm's own compliance officer - had concerns, the SEC wrote. In fact, Birkelbach's "complete failure" to take precautions despite obvious red flags "appear to involve some degree of intent," the agency said.
The securities industry has since developed better supervisory procedures, said Francis Curran, a securities lawyer for McCormick & O'Brien LLP in New York. For example, an investor in Lowry's situation now would probably receive a letter from the brokerage's clearing firm about suspicious activity, Curran said.
Nonetheless, supervisors still need to take warning signs seriously, especially concerns from compliance officers, Curran said. "That might be something viewed as a significant red flag."
(Reporting by Suzanne Barlyn; Editing by Linda Stern and Lisa Von Ahn)