What's A Small Investor Like You...

When Ezio Lombardi responded to a radio ad pitching a great new investment, the 50-year-old railroad mechanic from Denver thought he couldn't miss. Commonwealth Financial Group of Florida convinced the Italian immigrant he could earn back money lost in a penny-stock scam involving another company. But four months later, Lombardi's $92,000 stake had withered to just $6,000, with nearly half his funds eaten up by commissions.

Penny stocks strike again? Nothing quite so simple: Lombardi lost his money in options on futures contracts. These investments allow investors to bet on whether the price of commodities such as gasoline, cotton, or live hogs will rise or fall. If they're right, they can sell their contracts at a profit. If they're not, the contracts expire, worthless.

HARD SELL. While these complex derivatives mainly attract professional traders, a growing number of unscrupulous commodity-options firms are targeting small investors. For the most part, it isn't the investments themselves that are the problem. It's how they're marketed: Futures regulators say unsophisticated investors are being oversold on potential profits, underinformed about risks, and overcharged in commissions.

Brokers find selling options on futures to retail investors attractive for several reasons. Options lend themselves to a compelling sales pitch: Investors can lose only the "premium"--the money they invest up front--while profits can be many times the initial investment. In contrast, investors can lose far more than their initial investment with straightforward futures contracts--and brokerage firms can be on the hook if investors refuse to send in more money to cover margin calls.

In addition, because the average investor is ill-equipped to analyze options on futures, it's tough for them to make informed decisions. While sophisticated buyers have the skill to analyze properly the many factors driving the price of, say, orange juice, average investors are ill-equipped to gather the information themselves--let alone understand the complex mechanics of the options market. For example, court records show one trade where Lombardi was told that for every 1 cents increase in the futures price of heating oil, his option position would make him $420. But options seldom move in lockstep with futures. And since market volatility and the time left before the option expires may affect option values as much as the underlying commodity price, such profit predictions are rarely accurate. Add to the mix the fact that firms aren't required to determine whether options on futures are, in regulatory parlance, "suitable" for investors, as stmckbrokers must, and it's a situation ripe for abuses.

Brokerages that specialize in options are a hydra-headed bunch. When one firm's profitable life is cut short by regulatory pressure, another springs up in its place. Yet operators at commodity-options firms frequently stay in the business even after coming under fire from regulators. The employment history of Charles P. Hoffecker, the owner of Commonwealth Financial, is a case in point. Hoffecker previously worked at two firms during 1990 and 1991--First Sierra Corp. of Virginia and Trinity Financial Group of Florida--that shut down amid regulatory concerns. Since 1992, at least 10 options firms have shut their doors after regulators brought charges against them, according to the National Futures Assn.

"NO FRAUD." Now, it's Commonwealth's turn to attract regulatory scrutiny. The Commodity Futures Trading Commission (CFTC) recently targeted five firms in South Florida, including Commonwealth, that together had racked up customer losses of nearly $60 million. Three of the firms quickly shut down, but Commonwealth and another firm mounted strong legal defenses. On Aug. 31, a federal judge concluded that Commonwealth had indeed misled Lombardi and several others but that regulators had failed to show a pattern of systematic fraud. Commonwealth was free to operate as long as it maintained safeguards such as an independent review of taped sales calls. But after regulators returned to the judge with more evidence, he issued a harshly worded ruling on Dec. 28, saying that the firm was continuing to defraud customers even though under a court order to desist. Commonwealth was held in contempt of court.

Commonwealth's Hoffecker vows to pursue his court battle. "There was no fraud," he says, charging that he is being blamed for customers who gambled away their money while fully aware that commodity trades would be highly risky. Hoffecker describes Lombardi, who recovered part of his losses in a settlement with the firm, as a savvy investor feigning ignorance. And Hoffecker points out that Commonwealth provides a risk-disclosure statement making it clear that options on futures aren't for everyone. "No one puts a gun to his head. If he sends more checks and more checks, whose fault is that?"

Regulators, though, say many investors are bamboozled by such time-honored boiler-room practices as the hard sell. In all the recent cases, regulators found some brokers who exaggerated the likelihood of fat profits and minimized the risk of loss (table). Fast-talking brokers would gloss over commission charges and inflate the likelihood of big profits, such as when a broker from the defunct Trinity told prospects they could expect gains of 200% to 300%. In fact, most of the firm's customers were losing money.

OUTSIZE FEES. Hefty commissions make it tough for customers to come out ahead. Typically, small investors are unaware that commissions at respected firms can be surprisingly low. For example, Chicago discount commodity broker Lind-Waldock & Co. charges as little as $5 for certain options trades, and no more than $35. Commonwealth, which offers advice beyond what discount brokers offer, billed Lombardi and other customers $200 a trade, a typical rate for firms targeted in regulatory actions. Options firms claim that customers can make money even when paying such fees. With the leverage that options on futures afford, a modest market move can compensate for those charges, says Hoffecker. But the court's Dec. 28 ruling found that Commonwealth customers profit only when they bet correctly on "dramatic" market moves.

To top it all off, a CFTC analysis shows that Commonwealth has taken even more money from its customers in fees than its customers have lost in the market. The firm's commissions of $10.3 million between October, 1992, and August, 1994, represented 53% of customer losses.

The rise in commodity-options fraud may well result in tougher laws. But in the meantime, the words of Joseph F. Vargyas, a CFTC regional counsel, are worth heeding: "Options are no exception to the adage that if it sounds too good to be true, it probably is."


Below are excerpts from court transcripts of taped sales calls illustrating what regulators allege are misleading sales pitches for purchases of options on futures contracts.

-- To convince customer to purchase heating-oil options, salesperson informed customer that he could lose his entire investment but that "there was a remote possibility of losing everything" and "how can you lose when people are still buying heating oil?"

-- Salesperson "made the investment seem virtually risk-free, to the point that the prospect had to bring up the issue, telling [the salesperson] that it cannot be that easy."

-- Salesperson repeatedly told client that if the market went against him, the equity would not be lost. He said that a $33,000 profit was a "very conservative" projection, and if the client did not make a lot of money, he would be left with his original investment.

-- Salesperson spoke "very little about the risk involved in commodity options but talked a great deal about the $20,000 to $30,000 in profits I would make in one month on a $5,000 investment."


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