FOOL ON THE HILL
Full-service brokers who earn the bulk of their pay from commissions have an inherent conflict of interest. It's worse in a company with both brokerage and investment banking operations. UBS PaineWebber recently pulled a policy that fined brokers to placate investment bank clients. No one should need any more convincing to lose their full-service broker.
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If any of you still think that full-service brokers have incentives to make you money, please give me whatever you're smokin'. It has to be pretty good to survive the latest howler:
UBS AG's (NYSE: UBS) UBS PaineWebber brokerage unit last week reportedly instituted a policy assessing its brokers an unusual penalty. If brokers offer IPO or follow-on offering (a new share issuance by an already-public company) shares to customers at the offering price, and those customers sell them during the next 40 days before the stock price has moved up or down 10%, the company fines the broker 200% of the commission earned. Why? Because investment banking customers -- corporate managers who dimly understand the stock market except that up is good and down is bad -- don't like seeing their share price fall. It's bad for bonuses, options and stuff. A convenient scapegoat is the flipper, dolphin-like investors who allegedly buy the shares and quickly sell, purportedly creating an oversupply of shares and a slump in the share price. Investment banks, quite naturally trying to keep high-paying underwriting business, feel they have to do something -- and UBS PaineWebber was in the company of at least Morgan Stanley Dean Witter (NYSE: MWD). A UBS spokesman said that the policy is to ensure "the [financial] advisor places primary and secondary offerings in the hands of long-term investors." That absurdity -- and bad publicity -- most likely caused UBS PaineWebber to pull the policy a day later. Instead, the company will reportedly use software to track customers' trading and try to allocate IPO shares accordingly. This mess highlights why the full-service broker can be hazardous to your health. Investment banks trump brokers But let's be real. If there were enough demand for stocks, do you seriously think retail investors would have any access to it? "Hey, Mikey, I've got a few of these shares just for you" is a sales job, not an investing strategy. I'm just cynical enough to think that anytime someone whispers to me about getting in on the ground floor I'm about to lose my footing. Surprise: full-service brokers are paid by commissions Why the rule is stupid Joe Blue Chip isn't likely to be seduced into an IPO. He knows that he wants to invest in solid, well-managed companies with steady, if unspectacular, growth, for many years. He would be the best candidate not to sell once he's purchased, but he's the least likely candidate to make that buy. Can't you hear him? "You say it doesn't have at least ten years of SEC filings? You mean my grandmother couldn't buy its products when she was a girl?" Under the new rule, your worst prospect for NewThing is exactly the one your company says it allegedly wants. And Joe Trigger Finger? He's a love 'em and leave 'em kind of investor. Actually, he's not an investor at all, but a trader, trading stocks as if they were pork belly or gold futures. Joe is your most likely customer, and you appeal to him the way you convince anyone to buy IPO shares -- it's a special deal, you'll make quick money. No problem, "quick" is what he's about anyway. Except how do you get him to agree to not sell within 40 days -- unless he's facing a big loss or gain? This is the guy who's in and out fast all the time. Whether the stock moves or doesn't move, he's out anyway, moving on to the next "opportunity." The customer most likely to buy the stock is the least likely to hold it. That's why I don't believe a word of the company's spin about placing the shares with long-term investors, and you shouldn't either. The policy encourages brokers to sell IPO shares precisely to those who want or need them least. It increases the already huge inherent conflict of interest between full-service brokers and customers. The policy is one thing, and one thing only: a fig leaf for the investment bank to use in making sales pitches for underwriting deals. No wonder UBS PaineWebber pulled the policy a day after it appeared in The Wall Street Journal. Still unconvinced?
If this isn't enough, here's a closing story. One of my nieces -- I'll call her Stephanie -- got a call from her Merrill Lynch (NYSE: ML) broker, the son of another broker at the same firm who has served members of my family. (Sigh.) This genius suggested to my niece that it was time to "get out of" her U.S. investments and "into" Europe. She was supposed to accept that, but being someone to question everything, she asked why. "Because all the growth's over in the U.S. and Europe looks good." Stephanie, who had read the Gardners' You Have More Than You Think, said to me, "Even I knew that was bogus." This is why we will say over and over, year after year, until they drag us out of here babbling: You are the best person to manage your money. Investing is simple, but not easy. Read, study and have fun. Most people are better off in a broad-market stock index fund. If individual stocks are for you, get a discount broker, and you won't have any of the problems discussed here. If you need financial help, consider third-party independent advice from people who have nothing to gain by the financial decisions you make. (One source is TMF Money Advisor. There are others.) My best wishes for the most Foolish 2002! Tom Jacobs' (TMF Tom9) family won't talk to him anymore for fear of appearing in a column. To see his stock holdings, view his profile, which happily follows The Motley Fool's disclosure policy. Tom reserves the right to be wrong, stupid, or foolish (small "f"). Good thing.
Investment banks rake in huge fees underwriting IPOs and follow-on offerings. With demand for new shares down, there's less business from companies seeking to raise capital either through an IPO or follow-on offering. With tougher competition in a smaller market, the banks probably promise the moon -- their job is to sell as many shares as possible at the highest possible price -- and then flog the brokers to provide that moon.
Brokers are salespeople, and use every trick of the trade to do what their employer says. As long as they earn the bulk of their money from commissions on stock trades, their cost-benefit analysis is expressed at its most harsh by The Sopranos' brokerage operation: The office muscle beats up brokers who recommend anything other than this week's pump-and-dump, the customer be damned. Like car or real estate salespeople, there are good stockbrokers and bad stockbrokers, but what puts food on the table and a roof over their heads is commissions. Everything else is designed to get them. Beware friendship with your broker. Get a dog.
So the investment bank's brokerage arm "asks" its brokers to sell IPO shares in NewThing (Ticker: SUKR). You're a broker. Which of your clients do you think is going to be the most likely to buy NewThing and generate a commission? Joe Blue Chip who owns General Electric (NYSE: GE), Pfizer (NYSE: PFE), and PepsiCo (NYSE: PEP) and greets your sales pitch with "If it ain't broke, don't fix it," or Joe Trigger Finger who makes 100 trades in a year, and for some reason is willing to pay full-service broker commissions (lucky you)?
Sure, I picked two extreme examples to make a point, but take someone in the middle, and the conflict's still there. The person who might think he's getting an opportunity, but then finds he has to sell for some unforeseen reason, must endure his broker begging and pleading not to sell, or even -- let's play this one out -- offering to loan money against the shares. It's a dirty business, no doubt about it.
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