By Howard S. Meyers, Esq., CPA

After another dismal year for the stock market, many investors continue to suffer significant losses in their portfolios. However, while the overall stock market has declined, each investor’s individual losses may have been exacerbated by their stockbroker’s own negligence, which may include unsuitable investment recommendations, excessive trading and poor asset allocation.

During tax season, practitioners can provide an important value-added service during the preparation of their clients’ Schedule D of Form 1040. Rather than blindly entering each transaction on Schedule D, the practitioner should look for certain “red flags” that may indicate whether the client should be referred to an experienced securities attorney for a more thorough evaluation. After such a referral is made, the securities attorney can then determine whether the client may have a cause of action against his stockbroker.

In preparing the Schedule D, the practitioner initially should determine how many transactions are classified as long-term vs. short-term. A greater number of reported short-term trades could indicate that the client’s stockbroker was “churning” the client’s account. Churning occurs when, to obtain commissions, a stockbroker causes securities in a customer’s account to be traded with a frequency too great in light of the customer’s financial needs, resources or investment objectives.

The most frequently used statistical test used to determine churning is the turnover in the account. Total turnover is the ratio of purchased securities in the account to the net value of the account. It is calculated by dividing the total purchases in the account by the average equity. Equity is the amount that would be realized by the customer if the account’s assets were liquidated. Total turnover is annualized by dividing the total number of months in the analysis and then multiplying the number by 12. The Securities and Exchange Commission has recognized that although no turnover rate is universally recognized as determinative of churning, an annual turnover rate in excess of six is generally presumed to reflect excessive trading.

Another measure to determine whether a client’s account has been excessively traded is the break-even ratio. The break-even ratio determines what the minimum rate of return had to be just to break even and to cover transaction costs. The break-even ratio is the sum of all commissions, margin interest and fees, divided by the average equity in the account. The higher the break-even rate, the more difficult it is to make a profit, and the easier it is to determine that the stockbroker has churned the account.

In addition, the practitioner should review the client’s Schedule D to determine the extent of in-and-out trading and wash sales of the same securities. The number of in-and-out trades is simply computed as the total number of trades that have been executed in the account, the period of time within which these trades were executed, and the number of times the same securities were purchased, sold and repurchased. Both kinds of trading may indicate that the client’s account has been churned and may warrant further investigation by a securities attorney.

In preparing the Schedule D, the practitioner also may discover whether the client authorized each transaction being reported. Unauthorized trading occurs when trades are executed in a customer’s account without first obtaining specific approval, either by written discretionary authority granted to the stockbroker or by oral “time and price” discretion.

Unauthorized trading often occurs in the case of doctors and other professionals with hectic schedules, who often do not have time to read their monthly account statements or confirmations. By simply asking the client whether each trade reported on Schedule D was made with his prior approval, the practitioner can quickly determine whether the client may have been a victim of unauthorized trading and should be referred to legal counsel.

Finally, the most common claims asserted against stockbrokers are claims based on unsuitable investment recommendations. Under New York Stock Exchange rules and the National Association of Securities Dealers’ Rules of Fair Practice, a stockbroker is not permitted to recommend or solicit a trade or investment strategy before determining that the recommendation is consistent with the customer’s investment objectives, needs and risk tolerance. Such claims exist when: (1) the customer did not know or understand the risks of loss in a particular investment; (2) the customer did not have the financial ability to bear the potential risks; and (3) the customer’s investment objective was contrary to the type of investment solicited or effected by the broker (i.e., a speculative trade for a customer whose investment objective was conservative).

The practitioner should ask his client whether his stockbroker explained to him the risks of each investment reported on Schedule D before they were effected. Moreover, the practitioner can further probe the client by asking him to explain how each investment listed on Schedule D fitted into the client’s overall investment strategy (i.e., preservation of capital, current income, capital growth or speculation). If the client cannot explain why a certain investment was purchased and sold, it is possible that he may have been placed into an investment that is contrary to his investment objective or risk tolerance. Other warning signs that certain investments may be unsuitable include: the purchase and sale of stocks and mutual funds with a primary objective different from the client’s; the purchase and sale of certain corporate “junk” bonds, which provide the highest returns available in the fixed income market but also involve a higher risk; and the sale of uncovered (“naked”) stock options.

By simply looking behind the numbers, rather than just crunching them, practitioners may be able to detect potential misconduct by the client’s stockbroker and refer the client to a securities attorney for further investigation.