"Brokered CDs"; A Trap for the Unwary

ach month, the National Association of Securities Dealers (NASD) discloses its disciplinary measures taken against brokerage firms and brokers for violations of securities laws, rules and regulations. The common offenses are such matters as unauthorized trading, recommending unsuitable investments and excessive trading.

But this month, the NASD disclosed that one broker was barred and another broker was suspended for their actions in connection with "callable CDs". The two brokers consented to the findings that they misrepresented to customers the risks of callable CDs, including the lengthy term of the CDs and the limitations placed upon customers who need to liquidate them before maturity.

So what are these callable CDs, otherwise known as "Brokered CDs"? How do they differ from regular CDs? And what should investors know about them? In addition to the NASD's issuing new risk disclosure requirements for its brokerage firms, the Securities and Exchange Commission (SEC) has issued a publication entitled, "Certificates of Deposit: Tips for Investors", available at www.sec.gov/investor/pubs/certific.htm. Let's review its major points.

Historically, one purchased CDs at banks and thrift institutions. Regular CDs pay higher interest rates than savings accounts, carry FDIC insurance and require the purchaser to hold them until maturity - 6 months, 1 year, 5 years and so forth. Principal is returned at maturity, plus accrued interest. If the purchaser needs to redeem the CD before the maturity date, the purchaser is penalized by having to forfeit a portion of the accrued interest, but the principal is returned in full.

Today, CDs are offered not only through banks and thrifts but also through many brokerage firms and independent salespeople known as "deposit brokers". No matter how they are purchased, today's CDs have become more complicated with special features - or traps, for the unwary. Before purchasing a CD, one must read the disclosure statements carefully.

The SEC provides the following tips. First, find out when the CD matures, and ask to see the maturity date in writing. This is crucial because some CDs do not mature for upwards of 20 years. Elderly customers should be especially mindful of such long-term maturity dates.

Second, investigate "call" features, whereby the issuer of the CD (always a bank) has the exclusive right to terminate or "call" the CD. Know that a bank never will call a CD to benefit the customer. For example, if interest rates fall, the bank can call the CD, leaving the customer to purchase another CD paying lower interest rates.

Third, for brokered CDs, determine which bank or thrift is the issuer. This way, you can determine whether you have exceeded your $100,000 per bank or thrift limitation on FDIC insurance. Likewise, find out how the CD is to be held so that you can have the CD titled appropriately, again to ensure that you receive available FDIC coverage.

Fourth, research any penalties for early withdrawal. There may be no "penalty" for early withdrawal. But, under certain circumstances, you may be forced to forfeit some of your principal. This relates to a situation where interest rates have risen, and your CD (paying lower interest rates) no longer is as valuable to a subsequent purchaser.

Fifth, investigate the deposit broker. These individuals and entities may have customer complaint and disciplinary records. Be sure to investigate them before purchasing CDs from them.

Sixth, confirm whether the interest rate on the CD is fixed or variable. Some CDs pay high interest rates, but they are tied to the performance of a stock market index, such as the S&P 500. Other CDs pay "multi-step" or "bonus rate" interest rates that increase or decrease over time according to a pre-set schedule.

In conclusion, today's CDs are "not like your grandfather's" CDs. Be careful!

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James J. Eccleston is a securities attorney, representing investors as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He is a past co-chair of the Chicago Bar Association's Securities Law Committee, a past chair of its Financial and Investment Services Committee, a registered investment advisor and a licensed securities principal of the National Association of Securities Dealers (NASD). He maintains an informative website at www.FinancialCounsel.com. He is an equity partner with Shaheen, Novoselsky, Staat & Filipowski and can be reached at 312-621-4400.