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October 20, 2006 5:15 pm

Arne Alsin: The story brokers don’t want you to read

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This is a column that the brokerage industry does not want you to read. That is because it will embarrass them. Brokers don’t want you to know that they reap big profits by withholding important information from investors. Brokers don’t want you to know that they are the reason why shareholder voting has become a farce. And they don’t want you to know that they regularly and systematically discriminate between classes of investors.

The reasons for broker misbehaviour should come as no surprise. They misbehave because: (1) it is profitable; and (2) they can get away with it.

Brokers, as fiduciary agents, are supposed to act in the “best interests” of investors. But many brokers act in their own interests when they have an opportunity to generate more profits. Before I get to the cold, hard facts regarding the self-serving conduct of brokers, I will identify the root cause of the problem. That is, brokers wield too much power and influence.

There is no other asset class where brokers have such enormous power. A real estate broker or an auto broker, for example, is not able to lend your house or your car to someone else without your knowledge.

In the stock market, it happens every day. Brokers lend investor property to short sellers, often at annual yields in excess of 10 per cent, without notice to investors. After lending investor property, brokers have the gall to keep 100 per cent of the proceeds.

Broker lending of investor property generates $10bn a year for the brokerage industry. Because brokers are reluctant to share this booty, they wilfully and systematically discriminate between investors. They discriminate between those investors who have information and those who don’t have information.

Investors who know when their shares are lent (in other words, institutional investors) demand a piece of the action. And they should. Those investors deserve to be compensated when their property is lent to someone else.

Investors who do not know when their shares are lent (retail investors) are treated differently. Brokers regularly loan out the property of uninformed retail investors and keep all the proceeds. Those property owners cannot demand a piece of the action if they do not know about it in the first place.

In the brokerage industry, which I believe is collusive and anti-competitive, all retail investors must sign a “hypothecation” agreement when they open a margin account. This gives the broker the right to lend investor property without prior knowledge and without compensation to the investor.

The hypothecation agreement is an indefensible anachronism. The reward captured by brokers under the umbrella of the hypothecation agreement is outrageous, and it is not subject to normal open-market supply and demand forces.

Per the industry-standard hypothecation agreement, brokers are able to lend out investor property and secure high returns while putting none of their own capital at risk. So, all of the capital is put up by the retail investor; all of the reward goes to the broker.

The key to the ruse is this: keep the retail investor uninformed. Broker behaviour borders on the absurd in this regard. When a broker lends the shares of a retail investor to a short seller, who then sells the shares to someone else, the right to vote goes with the shares. To keep the loan a secret from the owners, brokers mail proxy voting materials to investors even when the broker knows that the shares have been lent to someone else.

The deceit is carried a step further. Even though the shares have been lent and the retail investor is not legally entitled to vote, brokers allow the investor to vote anyway. As a result, shareholder voting has become a farce. That is evident, in part, by rampant over-voting.

The common broker complaint – that it is too difficult to track shares for voting purposes – is a canard. That is because brokers already track shares pursuant to Internal Revenue Service rules.

Brokers track shares for tax purposes because they have to. They permit systematic violation of the “one share, one vote” rule because they can get away with it.

Arne Alsin is a portfolio manager for Alsin Capital and for the Turnaround fund.

arne@alsincapital.com

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