With small independent broker/dealers blowing up left and right, it’s become that much more important to know what kind of compliance regime your firm has and who your colleagues are.

Harrison Douglas, a small independent broker/dealer based in Aurora, Colo., is just one of dozens of firms that have recently folded. And the firm was at least partially compromised due to a $200,000 arbitration award involving an advisor at the firm named Charles DeLao, who made significant allocations in clients’ portfolios to various illiquid private placements.

$200,000 may not seem like a lot of money, but the firm’s president Douglas Schriner decided he couldn’t afford it. Schriner terminated DeLao when he refused to help with the settlement and when it came time for the client to collect, Schriner told the client he could only offer her partial payment. The client declined his offer and he closed up shop instead. A few days later, DeLao’s 27 colleagues were out of work. (As of June 21, FINRA suspended both DeLao’s and Schriner’s licenses for failure to comply with the award, and they won’t be able to work in the industry until they pay it off.)

“No small firm keeps that kind of money as capital,” said Schriner. “The rep [DeLao] should have stepped up and paid some, but walked away completely leaving us not only fully responsible for the settlement, but all of the defense costs. We were spent financially, emotionally and intellectually.”

While Schriner wouldn’t attribute the firm’s demise to this one award, it did push his firm over the edge. Prior to closing, the IBD had one other pending claim against it, and he knew the firm would need more time and capital on hand to deal with future complaints if he stayed open for business, Schriner told Registered Rep.

“I just couldn’t justify the continuation of fighting these battles—this adverse award has made my decision to exit the industry for me,” Schriner added. “I probably could have raised the money to pay the award, but then I would have to raise more to defend the firm from more attacks.”

The Claim

Claims filed with FINRA allege that DeLao put nearly 82 percent of his elderly client Rosemary Gilbert’s assets into a various illiquid private placements, including $1.158 million in Medical Capital and Provident Royalties, which have since blown up. Gilbert is 72. Other investments in her portfolio included non-publicly traded, illiquid real estate deals from United Development Funding, Desert Capital and ETR Pasco. Gilbert’s daughters, Robin Thomas and Laurie Knapp, also allege DeLao put a significant amount of their assets into Medical Capital and Provident, when “they wanted fixed income and preservation of capital,” according to the claim. Meanwhile, Harrison Douglas’ president sent emails to DeLao telling him to stop selling Medical Capital to new clients, according to Thomas. (Schriner admits he sent such emails.)

Gilbert, Thomas and Knapp claim these investments resulted in a $2.229 million loss and filed an arbitration claim against DeLao and his broker/dealer Harrison Douglas. Thomas was awarded the $200,000, while other two claims were denied. (Attorneys on both sides backed out prior to the hearing, so neither side was represented.) “There was unfairness in the way it went down,” Gilbert said.

“We showed evidence that Robin’s mother wanted private placements as an alternative to the stock market wherein they were losing money,” DeLao wrote in an email to Registered Rep. “We showed evidence she wanted the investments in light of her financial circumstances at the time.”

In September 2007, Thomas sold her business and came to DeLao with $500,000, Thomas said. (While this was a small amount in comparison to her net worth, she claims it was a gift for her father, to be used to generate income for him in retirement. On her account application obtained by Registered Rep., Thomas said her risk tolerance was conservative to moderate, while her objective was capital preservation and growth and income.) Thomas claims DeLao put $350,000 of the $500,000 in Medical Capital and Provident and the rest into a BMW partnership, which has performed well but is very illiquid and is proving difficult to get out of. Knapp also alleges DeLao put $145,000 of her funds into Provident, and other $84,600 into the illiquid UDF and Desert Capital funds.

“Both investments [Thomas] agreed to as evidenced by acceptance documents and emails in file,” DeLao wrote. “She lied in testimony that these two investments were to be safe, capital preservation when in fact she agreed to an income investment for her father and a growth investment to offset interest rate and inflation risk of her bond portfolio.”

“No right, sane person with any knowledge of our industry would agree that what they did was suitable,” said Bob Kargenian, founder of RIA firm TABR Capital Management, who is now handling Gilbert’s portfolio.

According to FINRA and Meridian-IQ, seven of the firm’s reps have landed at other firms, including Sandlapper Securities, Berthel Fisher & Co. and Concorde Investment Services. But at least four FAs are no longer registered with FINRA, and others are likely out there looking for a new home, a difficult task for reps coming from a tainted firm.

Due Diligence

The lesson here? Do your due diligence, especially if you are planning to join a small b/d. This includes checking out their compliance procedures and history as well as the other advisors who work there. Smaller b/ds are more vulnerable to client claims just by virtue of size, said Philip Palaveev, president of Fusion Advisor Network. Indeed, a single arbitration can bring a smaller firm down, said Jodie Papike, executive vice president of Cross-Search, a third-party recruiting firm. Advisors want to work at small firms because they can be more nimble, but small firms come with a particular set of risks, she warned. Reps should look at the firm’s financials, including net capital and reserves, as well as any pending arbitrations or customer complaints. She suggests talking to some of the advisors registered with the firm and asking if they get paid on time and whether they have payroll every month.

And of course, reps should check out the records of the other advisors affiliated with the firm. “At the end of the day, it’s a group effort,” said Alois Pirker, Aite Group analyst. If a firm’s brand is damaged, it can put an advisor in a tough position, he said. “Understanding the other FAs at one’s b/d matters too; one bad apple can bring down the firm and brand all of the FAs,” agreed Roame.

If you’re moving to a new b/d, it would help to ask the firm if they have advisors with issues from the past, such as arbitrations and customer complaints, said Papike. B/ds often walk a fine line between keeping reps safe and keeping them happy, she said. If the b/d will say ‘yes’ to everything you ask for, that could be a warning sign that they’re not doing as good a job on the compliance front, and that could lead to trouble down the line, she added.

Knowing the Risks

In emails, Schriner warned DeLao about Medical Capital and about its management of client assets. He eventually told DeLao to stop selling Medical Capital to new investors. But Schriner said he has no way of knowing whether DeLao read the emails and that Thomas was not considered a “new investor.” (Thomas said her one-year Medical Capital note vested in September 2008, so she could’ve redeemed her money, but DeLao reinvested it.) Meanwhile, DeLao said the email from Schriner referred to MedCap funds IV and V, while he had the family in MedCap III.

Papike said it’s the job of the b/d to supervise its advisors and conduct the due diligence on the investments. “If the broker won’t comply, you terminate that person.” But Schriner said he and his reps are not fiduciaries or asset allocators. “They accepted the risk, and they said they did by signing the selling agreements,” said Schriner. DeLao echoed that sentiment. “She requested growth and income to mitigate long term risks of her bond portfolio, which she accepted,” DeLao claims.

While Thomas admits that her mother and sister did not read the paperwork and didn’t know what they were getting into, she claims there was no communication from DeLao about the risks of these investments.

“It’s difficult to capsulize four days of testimony and evidence,” DeLao wrote. He said there were documents and signatures showing that they knew and understood what they were purchasing.

“The moral of this story is we trusted Chuck and the firm he worked for, didn’t read the documents and followed his advice, and signed the documents he put in front of me,” Thomas said. “They are a buyer beware company and we found that out too late.”

Schriner was right to say the firm is not held to a fiduciary standard. (That could change.) The firm is held to a suitability standard, however, said Robert Ross, senior counsel with MarketCounsel, a business and regulatory compliance consulting firm. This means that based on the client’s risk profile and what investments they have, the rep can only recommend the client buy securities suitable for his or her situation. When asked about having over 80 percent in private placements, “It sort of inherently makes you raise your eyebrows,” he said. “Overconcentration is one of the largest red flags for consumers and for lawyers who represent b/ds.” Schriner argues that the concentration issue is moot because it’s not their job to “allocate assets,” but rather to raise money for corporate America.

“Our departure from the industry was a function of the environment and not any individual or action,” Schriner said. “Capital formation is the reason the industry exists – if you kill the goose, the golden eggs stop.”

In a case like this, where the litigation impacts the bottom line of the firm and causes them to withdraw their registration, the creditor has to chase her money, Ross said. Thomas has the option of taking the judgment from FINRA and handing it off to a local court that has jurisdiction over the person.