Brookstreet Securities Collapse: Where Were the Regulators?

The recent collapse of Brookstreet Securities raises serious questions about the efficacy of  regulation by the SEC, the NASD and state regulators.  In late June, Brookstreet fell below net capital requirements and shut it doors after its clearing firm, National Financial Services (“NFS”) suddenly wrote down the price of extremely risky and illiquid collateralized mortgage obligations (“CMO’s”) that Brookstreet had sold to its retail customers.  Brookstreet’s headquarters in Orange County, California provides an ironic backdrop for this sordid story, since Orange County itself lost millions buying CMO’s in the early 1990’s. 

            Publicly disclosed information indicates that Brookstreet perpetrated a massive fraud on its customers.   CMO’s are by their nature unsuitable for sale to all but the most sophisticated and risk-tolerant investors (see NASD Notice to Members 93-73); yet it appears that the firm’s representatives falsely marketed the complex CMO’s, which included “interest only strips” and “inverse floaters,” to elderly and unsophisticated investors, as low-risk “bonds” guaranteed by government agencies.   Investors were not advised that the CMO’s amounted to high-risk bets on the direction of interest rates.  Worse yet, Brookstreet recommended that investors use margin accounts to buy the CMO’s.  Accordingly, following the NFS markdown, many investors found that they not only have lost their principal, but now owe NFS hundreds of thousands, if not millions, of dollars.  These investors face the difficult decision whether to seek recovery of their principal from NFS, thereby risking an adverse collection action.

            Although the circumstances of the price increase remain unknown, interest rate movement between May and June appears to have been relatively modest, with the one-year LIBOR rate increasing by only 6% from 5.41% to 5.67%, and the prime rate increasing by only 3% from 7.75% to 8.00%.  Indeed, because investors can be expected to pre-pay mortgages when rates go down, rather than up, as here, the price decline of the interest-only strips marketed by Brookstreet cannot be explained by market forces.  This raises the question whether NFS’ pricing was arbitrary to begin with.  Information on the Internet indicates that Brookstreet sold small “odd lots”of CMO’s to its customers.  Yet, NFS allegedly priced the retail CMO’s as if they were sold in the larger blocks traded by Brookstreet.  Larger blocks of CMO’s would be expected to be more liquid and more valuable than the small quantities of securities sold to Brookstreet’s customers. 

            Therefore, it appears there is plenty of blame to spread around.  Brookstreet’s management encouraged the sale of unsuitable securities to its customers using fraudulent sales tactics.   NFS may have arbitrarily overpriced, and then market down, the value of the CMO’s.  Brookfield’s disclosed business model of  allowing representatives to work out of their homes, which were designated as one-man “branch offices,” should have caused regulators to review the efficacy of the firm’s supervision during regular examinations that presumably occurred on a regular basis.  Yet, the existence of multiple layers of regulatory jurisdiction and review did not detect this fraud in time to help hundreds of investor victims.