Saturday, May 28, 2011
Clearing Firm Rattles Investors
Penson, which clears trades for many online brokers, reveals it holds illiquid bonds tied to a former director. Investors needn’t panic, but they should closely monitor the company’s response.
A recent research note from Sandler O’Neill analyst Richard Repetto set traders’ and investors’ nerves on edge when he detailed clearing-outfit Penson Worldwide’s revelation that it held $42.6 million of possibly illiquid bonds issued by a horse-racing-track operator linked to a Penson director. Much ink and many pixels have been spilled discussing what the company’s extremely belated regulatory disclosure means. The immediate effect was clear: Within days, the company’s stock-market value was nearly halved, to about $3.12 a share. And the director resigned.
The news prompted us to look again at our annual review of online brokers ("Making the Right Connection,” March 14). Quite a few of them clear their trades through Penson (ticker: PNSN). The firm specializes in clearing derivatives transactions, so it was no surprise to see options heavy-hitters like eOption, OptionsHouse, thinkorswim, TradeKing and tradeMonster on its customer list. (Thinkorswim has not yet been completely folded into the TD Ameritrade clearing operation; its separate customer base still clears its transactions at Penson.) Also on the client list: A.B. Watley, ChoiceTrade, Cobra Trading, Lightspeed Trading, MB Trading, SogoTrade, SpeedTrader, TradingBlock and Zecco.
We also got lots of e-mails from readers asking, in essence, “What will happen to my money if Penson collapses?” One wrote that he was closing an account at a firm that cleared through Penson, and thanked me for the table in our annual review that gave him ideas on where to transfer assets (see “Barron’s 2011 Online Broker Review: How the Brokers Stack Up").
Penson has maintained that the bond position won’t have any meaningful effect. In an e-mail via Penson’s public-relations office, Vice Chairman Daniel P. Son explained that the “situation occurred as a result of an expansion of our disclosure in our most recent Form 10-Q about certain receivables where the collateral had reduced liquidity. Unfortunately, we believe, investors misunderstood some of the information.” Son said that Penson will recover those receivables without a loss, but even if a loss did happen, there would be no impact on the firm’s ability to clear trades, since the funds involved are separate from Penson’s regulatory capital. However, Penson CEO Phil Pendergraft said later at an investor conference that the company could have a “material” loss after writing down the loan. He said he still expects Penson to post a profit this year.
SHOULD YOU WORRY IF YOUR broker clears through Penson? You should watch how Penson responds to this mess, but there’s no need to move money based on its current financial position. It takes a near-perfect storm, including a major market drop and a lot of trading on margin, to force a clearing operation out of business. We witnessed a failure in mid-2008, when North American Clearing went under, tangling trades for its brokerage clients and their customers for a month. That doesn’t seem to be the case here.
Even if the illiquid investment bled into Penson’s regulatory capital, there is insurance through the Securities Investor Protection Corp. (SIPC), a federally mandated entity funded by broker-dealers, that covers up to $500,000 of stocks, options and bonds per account. Futures contracts, commodities and currencies are among the assets ineligible for coverage. Most brokers carry additional insurance, called excess SIPC coverage, that insures assets above the $500,000 ceiling. Check out the SIPC Website (http://www.sipc.org) to learn more.
If you are not borrowing money from your broker by using margin, or shorting stock, your trades don’t make it onto the clearing firm’s books. If you are using margin, then the clearing firm has collateral from you on the other side of its balance sheet, in case there’s a problem. Penson’s role in a transaction is to process trades electronically for its broker clients, and to make sure that the appropriate funds are in the right place at the right time.
Several executives of online brokers who clear through Penson spoke with us on the condition that their names not be used. The general reaction was that the disclosure of the illiquid loan was a public-relations disaster rather than a sign of impending financial doom.
One said that Penson’s business will be fine, but that its management has a lot to answer for. “They should disclose every security on their books to regain confidence. They should fire everyone running it, and start over with new management,” fumes the brokerage official. (Penson director Thomas R. Johnson resigned his board post on May 12. Johnson is chief executive of Call Now, which manages the Texas race track for the company that issued the bonds. Call Now was also an early investor in Penson.)
AN OFFICIAL AT ANOTHER BROKER says that regulators at the Securities and Exchange Commission and the Financial Industry Regulatory Authority “are all over this.” If Penson were to try to hide something from the regulators, “they’ll get a nice orange jumpsuit to wear for a few years.” Although he’s disappointed with the firm, the executive notes that Penson easily meets all regulatory standards. At a firm geared to active options traders, a senior manager compares clearing firms to waiters: “If they do a good job, you never think of them.” Penson has more than $100 million in excess regulatory capital, according to Vice Chairman Son.
This same official points out Penson’s technology for clearing derivative and futures trades is “way ahead of everyone else.” The company, he notes, serves not just brokerage firms but hedge funds and proprietary trading firms.
Most important for Penson, none of these executives were about to pull the plug on their clearing relationship with the firm, and few of their customers have made any noises about moving their accounts. One brokerage official said that if his firm saw customers leaving due to their clearing operation, then it would have to reassess the relationship. Changing clearing firms is a huge, time-consuming undertaking.
It appears to me that moving an account away from a brokerage that clears through Penson just because of this disclosure would be a major time-sink, without much return. However, I do believe that some house-cleaning is needed—quickly—at Penson, and that it should discuss its practices and its services with brokerage customers. No doubt, Penson’s rivals already are reaching out to many of these brokers.
Published in Barron’s, May 23, 2011.