FINRA Sanctions Three Brokers Over CMO Sales

Long-time HW readers may recall an earlier brouhaha over failed Orange County, Calif.-based brokerage Brookstreet Securities Corp., and regulators’ subsequent investigation into collateralized mortgage obligations, or CMOs; at the time, the Financial Industry Regulatory Authority said it was probing individual brokerages over suitability concerns tied to CMOs. That investigation yielded at least three culpable parties on Thursday, FINRA said, although not tied to Brookfield; the non-governmental regulator said in a press statement that it had sanctioned three brokers at two firms for misconduct tied to selling CMOs to retail investors. At the time the investigation was originally announced in January, HW had speculated that concern at FINRA was not concerned with CMOs explicitly — which are plain-vanilla REMIC structures, and literally the kind of securities your grandmother might own — but with an exotic variant of the traditional REMIC. We’d speculated on the possibility that some brokerages were putting retail investors into so-called IO strips (IO, for interest only). FINRA’s press statement proves us partly right; while the three brokers sanctioned were, in fact, putting retail investors into variants of the traditional CMO, that variant was not an IO strip, but instead a series of inverse floaters. (Floating-rate CMO tranches, or floaters, pay a variable rate of interest which is usually tied to LIBOR; inverse floaters are extremely volatile and thinly-traded instruments, which, as their name suggests, float inversely to LIBOR.) A start, not an end, to investigations FINRA said it permanently barred brokers Cindy Schwartz and Brian Berkowitz from the securities industry, while a third, John Webberly, has been suspended for two years. Regulatory officials suggested the sanctions would not be the last handed out. “These are FINRA’s first enforcement actions arising from our ongoing investigations into abuses in the marketing and sales of mortgage-backed securities such as CMOs to retail customers,” said Susan Merrill, FINRA chief of enforcement. “Brokers and firms have an obligation to ensure that they recommend these securities only to those customers for whom they are a suitable investment — namely sophisticated investors with a high-risk profile. Webberly, Schwartz and Berkowicz failed to fulfill this obligation when they recommended ‘inverse floaters’ to retail customers with little or no investment experience.” Since 1993, FINRA has published warnings that inverse floaters are suitable only for sophisticated investors willing to take on high levels of risk. In its investigation, FINRA found that Webberly made unsuitable recommendations to four customers to buy these securities and that in making these unsuitable recommendations, he misrepresented or omitted material facts. FINRA further found that Schwartz and Berkowicz made unsuitable recommendations and misrepresented material facts in connection with sales to two and three of their customers, respectively. Webberly’s customers suffered realized losses of approximately $250,000 from their investments, Schwartz’s customers suffered losses of approximately $95,000 and Berkowicz’s customers lost approximately $190,000. The allegations of misconduct here are eye-opening: FINRA’s investigation found, for example, that Webberly recommended to two couples with no prior investment experience that they invest in inverse floaters, falsely claiming that inverse floaters could not lose their principal, that there was no risk in margin borrowing costs exceeding the income earned on the investment, and that the investment was risk free. Similarly, both Berkowicz and Schwartz recommended CMO investments to investors with limited or no prior investment experience and made material misrepresentations about the characteristics of inverse floaters — in some cases describing CMOs as secured government bonds where an investor could not lose any money. For more information, visit

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