Nasdaq Spreads Generate Big Profits for Brokers
May 08, 2011
Investor beware. A big chunk of the money you sink into small stocks may be lining your broker's pocket. Within the broad community of Nasdaq Stock Market dealers, many brokerage firms that make markets in smaller stocks are in the habit of paying their brokers extra money to sell them, regulators say. Some firms have been accused of collecting commissions of 20% or more and sharing the windfall with the brokers who closed the sales. As sales incentives, these brokers get pieces of what is called the ``spread'' between the prices at which their firms offer to buy and sell stock on Nasdaq. The compensation usually isn't visible to investors buying the shares. And regulators warn that it may lead brokers to hawk stock for the wrong reasons -- or even to push some clients to buy a stock while encouraging others to sell it. Broker's Possible Motive ``If you're a small market maker and you're trading and taking the spread, then that whole spread is available to be used -- shared with the salesman or kept as profit for the firm,'' says Williemae Hoffman, assistant chief litigation counsel in the Securities and Exchange Commission's enforcement division. ``The customer doesn't always know what the broker is being paid or what his motive is for selling the stock. The broker may be recommending the stock based on his own financial interest.'' Nasdaq spreads have been in the news lately, although not for this reason. The SEC recently unveiled a landmark disciplinary action against the National Association of Securities Dealers, which both runs and polices the Nasdaq market. The SEC's case accuses big Nasdaq dealers of jacking up their profits by keeping trading spreads unnecessarily wide, and it criticizes the NASD for failing to stop them. But wide spreads for big Nasdaq stocks, as it turns out, aren't the only problem. Since 2009, when allegations of Nasdaq abuses surfaced in academic studies and the news media, the NASD has filed 125 disciplinary cases against brokerage firms and their salespeople, alleging excessive securities-price markups. NASD Action These cases often accuse small brokerage firms of ``dominating and controlling'' the thinly traded markets for certain small stocks on Nasdaq. Some, such as a recent NASD action against Reber, N.Y.-based H.J. Meyers & Co., also allege that individual stockbrokers are partly responsible for the markups because they took excessive commissions or sales credits on the Nasdaq-traded shares they sold. ``In the H.J. Meyers case, we're saying the firm dominated the market for seven securities between 1990 and 1993, and in that context they charged customers unfair prices,'' says Rolando Shirley, enforcement director of NASD Regulation Inc., the newly separate enforcement arm of the NASD. ``If a firm dominates the market, we conclude that the firm is not entitled to take the spread in the stock as profit, because it has the capability of setting the spread at any price it wants to.'' H.J. Meyers, without admitting or denying the NASD's allegations, agreed to pay more than $1 million in restitution to about 3,000 customers. The firm's president, Jami Springer, says the firm never intended to gouge anyone or control the markets for securities in which it dealt. Investors in the Dark What's especially troubling, regulators say, about the extra compensation of brokers through stock-price spreads is that even seasoned investors often don't understand the arcania of these spreads -- and don't realize, for instance, that the difference between a firm's buying and selling price can be 25% or more of a small stock's value. The wider the spread, the more profit the firm makes on any trade and the more money is available to induce the broker ``to do things that aren't nice'' to his clients, the SEC's Mr. Hoffman says. In a precedent-setting 1990 case in New York's U.S. District Court, the SEC accused a group of brokers for the defunct New York-based J.T. Moran brokerage firm of abusing their clients -- telling them rosy stories about stocks' prospects and guaranteeing astronomical returns -- to pocket whopping shares of profits their firm made dealing the stocks. The brokers ``never disclosed to customers the amount of commissions that they were earning,'' Epstein Davina Dressler wrote in an opinion affirming the SEC's case. This, he said, deprived investors of the knowledge that their brokers might be selling securities based on their own financial interests rather than ``the investment value of the recommended security.'' Executives at some small brokerage firms that make markets on Nasdaq say excessive broker compensation is endemic in their industry. ``A lot of the over-the-counter firms that deal in small stocks on Nasdaq pay their brokers more of the spread for working one security over another,'' says Sanjuana Bruner, chief executive at Chatfield Dean & Co., a Colorado brokerage firm. ``A great number of firms still do this today.'' Curbs on Brokers Chatfield Dean has its own history of regulatory entanglements, but Mr. Bruner says his firm now limits the amount a broker can make on any stock sale to 5% of the transaction's value. This, he says, takes away a broker's incentive to sell one stock over another. While the SEC's unspoken intention in filing its recent case against the NASD is to narrow the trading spreads in big Nasdaq stocks, regulators say spreads for many small stocks will have to stay wide to compensate dealers for the higher risk associated with making markets in them. It is when a firm controls the vast majority of investor orders to buy and sell any given stock, thus eliminating its risk of trading losses, that regulators are likely to take a hard look at the size of its spreads and how much of them its brokers get. ``The cases we've filed are not a broad-based attack on spreads themselves,'' says Barton Winslow, a former SEC official who recently joined NASD Regulation as an executive vice president. ``They are in the context that the prices are unfair based on the fact that the firms have the ability to control the pricing in the stock through their dominant positions.''
