Glossary of Important Financial Terms
Securities arbitration is a dispute resolution process involving a neutral third party to act as both judge and jury. In securities fraud arbitrations, that neutral party is a panel of 1 to 3 persons jointly selected by the parties from a list that the administrator of the arbitration provides. In investment disputes with brokers and brokerage firms, arbitration is the method most frequently used to address investors’ grievances. It normally takes much less time and is less expensive than a court trial.
Churning (or Excessive Trading)
When brokers engage in excessive trading for the purpose of generating commissions, this improper practice is called churning and can be grounds for a claim against the brokers.
Discretionary accounts are accounts in which brokers may buy or sell securities without their clients’ consent for individual trades. Generally, clients must sign agreements in advance which give permission for the brokers to trade in the account. These agreements may include specific stipulations regarding the trading activity that is allowed.
A key tenet of prudent financial planning is diversification. If a portfolio includes many different types of investments, the portfolio is more likely to draw higher returns with lower risks than a portfolio that is overconcentrated in one type of investment. Diversification allows for possible sharp declines in a specific sector to be offset by profitable investments in other sectors.
Financial Industry Regulatory Authority (FINRA)
FINRA regulates securities firms in the United States. FINRA’s mission is to “protect investors and market integrity through effective and efficient regulation of the United States securities industry.”
Initial Public Offering (IPO)
An IPO or “public offering” is the first sale of stock by a private company to the public. IPOs are normally initiated by small companies, but occasionally large privately owned companies will initiate an IPO if they want to be publicly traded.
Liquidity (or Marketability)
Liquidity measures the ability of an asset to be converted to cash quickly.
Margin accounts are brokerage accounts in which the brokerage firm lends money to clients to purchase securities. The loan is collateralized by cash and the securities in the account. If the value of the collateral securities drops low enough, clients can be required to deposit more cash or sell some of the securities at a loss.
If brokers make incorrect statements about investments which “misrepresent” material facts relating to the investments, these statements can be considered misrepresentations and a breach of fiduciary duty.
North American Securities Administrators Association (NASAA)
NASAA is an organization of state securities regulators devoted to investor protection. By organizing state securities agencies, NASAA provides investigation of violations of state securities laws, as well as education for the investing public.
National Association of Securities Dealers (NASD)
The NASD was a self-regulatory securities industry organization responsible for oversight of NASDAQ and over-the-counter markets. NASD merged with the New York Stock Exchange’s regulatory body in 2007 to form the current oversight organization known as FINRA.
Ponzi schemes are a type of fraud in which investors are paid with subsequent investors’ investments, rather than by returns from the invested funds. When funds are diverted in this way from new investors to previous investors, a large portion of the investments are also diverted to those perpetuating the scheme, all under the guise of an upstanding, high-return investment opportunity. All Ponzi schemes are destined to fail and are highly fraudulent investments.
Risk tolerance is the amount of variability in returns that investors are willing to withstand. An understanding of an individual’s risk tolerance is important when investing.
Securities and Exchange Commission (SEC)
The SEC is a United States government commission created to protect investors and regulate securities markets. The SEC also oversees corporate takeovers, and most securities offered in the U.S. must be registered with the SEC.
Brokers who have bought, sold, or solicited securities without the formal approval of their brokerage firms have engaged in “selling away” from the firm. Such securities are generally not recorded on the firms’ books and are not monitored and supervised by the firms. Selling away violates FINRA rules and other securities laws and poses significant risks to the investors.
Unauthorized trading occurs when purchases, sales, or trades in investors’ accounts are conducted without investors’ permission.
Brokers have a duty to make sure that investments they recommend to their clients are appropriate or “suitable” for the particular clients. Investors have different financial backgrounds, situations, and goals when making investment decisions. An investment that is suitable for one investor may be entirely inappropriate and high-risk for another. If brokers do not recommend suitable investments for their clients, the investors may have grounds for a claim to recover losses.