Taking Stock: Insuring Securities Broker/Dealers in the New Millennium in the New Millennium

Percentage of American Households with Stock Market Investments C. Conda & D. Clifton, National Review, 10/18/06

Percentage of American Investors Who Purchase Mutual Funds through Financial Professionals USA Today, 3/23/05

Percentage of Mutual Funds Purchased Directly from Fund Company USA Today, 3/23/05

INCREASING IMPORTANCE OF FINANCIAL PROFESSIONALS 71% of stock investors rely on professional advice in choosing their investments

Comparison of Market Performance to # of Cases Filed Dow Jones, S&P 500 and NASDAQ (10/91 – 10/06) NASD Statistics per website

Controversies Involved in Arbitration Cases NASD Statistics per website

Security Types Involved in Arbitration Cases *Certificates of Deposit were first tracked in January NASD Statistics per website

How Arbitration Cases Close NASD Statistics per website * All Other reasons for closed includes cases closed by: Stipulated Award, Bankruptcy of critical party; Uncured Deficient Claim; Forum Denied; Stayed by Court Action, etc. Note cases counted as closed in this report do not include those cases that closed and were then reopened.

Percentage of Customer Awards in Arbitrations by Year NASD Statistics per website Note: Percentage of customer claimant award cases has been recalculated to reflect only instances in which investors as claimants recovered monetary damages or non-monetary relief.

SECURITIES EXCHANGE COMMISSION Primary Overseer/Regulator of U.S. Securities Markets Oversees Self-Regulatory Organizations (NASD, Stock Exchanges, etc.) Authority includes Enforcement Actions against b/d’s and individuals for violations of securities laws

NASD World’s largest private-sector regulator of financial services Registers securities firms Writes rules Examines for compliance Brings enforcement actions

NASD Notices to Members Provide notice of recently approved rules & rule amendments Solicit comment on proposed rules/amendments Legal interpretation & compliance guidelines

Central Registration Depository (CRD) Central licensing and registration system for U.S. securities industry Contains records of more than 6,800 b/d’s and 660,000 registered individuals

Registration, Testing & Qualifications 2 levels of qualification/registration Registered representatives Principals

Series 6 Investment Company/Variable Contracts Representative Authorized to sell only investment company products (e.g., mutual funds and money-market funds) and variable annuities Series 7 General Securities Representative Entitled to sell all types of securities products, with the exception of commodities futures (which require a Series 3 license). TYPES OF LICENSES

Series 24 General Securities Principal This would entitle the holder to supervise trades involving corporate securities, direct participation programs (DPP’s) and investment company/variable contracts. Series 63 Uniform Securities Agent Qualifies candidates to sell securities and give investment advice in those states that require Series 63 registration TYPES OF LICENSES (cont.)

OTHER CERTIFICATIONS /DESIGNATIONS RIA (Registered Investment Advisor) CFP (Certified Financial Planner) CLU (Certified Life Underwriter)

BROKER FEES: FIXED V. COMMISSION BROKER FEES: FIXED V. COMMISSION Fee-Based v. Commission per Trade Conflicts in each?

THE “MERRILL RULE:” Tempest in a Teapot? SEC Rule passed in April 2005 Allows b/d’s to offer fee-based accounts without registering as Investment Advisors as long as advice is “incidental” to Brokerage Services

Broker Prohibited Conduct Recommending unsuitable investments Unauthorized trading “Churning” (Excessive trading to increase commissions) “Switching”/Break Point Sales

Broker Prohibited Conduct (cont.) Misrepresenting or failing to disclose material facts Conflict of interest Guaranteeing there will be no monetary loss, making price predictions or agreeing to share in losses

Broker Prohibited Conduct (cont.) Purchasing/selling security while possessing material, non-public information “Selling away” “Selling away” Using manipulative, deceptive or fraudulent device affecting transaction

Broker Prohibited Conduct (cont.) Conducting private securities transactions/sharing accounts “Front running” Failing to use reasonable diligence to ensure order is executed at best possible price

FAILURE TO SUPERVISE Principal can be liable for actions of broker who engages in prohibited conduct if principal “failed to properly supervise” the broker

NASD ARBITRATION All industry disputes (member v. member, member v. registered rep., etc.) are subject to mandatory arbitration (except employment discrimination claims Customer disputes subject to mandatory arbitration only if there is a signed, enforceable arb. agreement

NASD Arbitration (cont.) NASD Code of Arbitration Procedure sets rules/procedures Up to 6 years to file Claim Initiated by filing Statement of Claim

NASD Arbitration (cont.) 1 or 3 Arbitrators (depending on amt in controversy) Minimal Discovery (no depos, etc.) FINAL AWARD IS NOT APPEALABLE (absent evidence of fraud, etc.)

Looking Ahead: Evaluating B/D Risk in the New Century “DOW 12,000”: Another Bust Coming? “Alternative Investments:” The Next Tech Market? Increased Regulation = Decreased Risk?