By: Jason R. Doss and Richard Frankowski
The stock market has a long history of volatility that can send wild speculators to yacht dealerships and conservative retirees back to the workforce. The downturn of 2008 was no different. In 2008 alone, America suffered a historic loss in wealth totaling approximately $10.2 trillion. Over $6 trillion of that amount was attributed to losses in the stock market.
Typically, American investors hire financial professionals (commonly referred to as stockbrokers or financial advisors) to make sound investment decisions. The nature of the relationship between a stockbroker and a client is one based on trust in that professional’s perceived financial acumen. In fact, brokerage firms aggressively market themselves as skilled advisors competent to handle every aspect of their clients’ financial life, from investments to mortgages, life insurance, long-term care, estate planning, and charitable giving. Furthermore, brokerage firms often advertise that their financial advisors will monitor investments after a recommendation to purchase a security to ensure that the investor meets his or her long term investment goals.
Studies in behavioral finance demonstrate that securities brokers are highly motivated to cultivate their clients’ trust and allegiance, and clients have powerful incentives to believe that such advisors are trustworthy and acting solely in the client’s best interests. Obtaining a client’s trust and confidence, and convincing the client that he or she should rely upon the investment advice given, is at the heart of the broker/client relationship.
In many circumstances, investor losses are caused by bad investment advice and in some instances, outright financial fraud. When this occurs, investors have a variety of legal claims that can help them successfully recover some or all of their losses. Unfortunately, investors typically do not have the capability and/or investment knowledge to determine whether their losses are caused by malfeasance or whether they were simply a natural consequence of investing in the stock market. As a result, the vast majority of investors do not even think to find out whether they might be able to recover their losses from advisors and their firms. Even fewer know that they may have legal recourse. Statistics provided by Financial Industry Regulatory Authority (FINRA) Dispute Resolution, the organization that sponsors the arbitration forum handling virtually all disputes between financial firms/financial advisors and consumers, show that only 16,255 cases have been filed by consumers since November 2007. If you assume $6 trillion in stock market losses in 2008, these 16,255 cases amount to approximately one lawsuit for every $370 million in losses.
Why are the vast majority of disputes between financial services firms and their customers resolved by FINRA Dispute Resolution? The answer is simple: pre-dispute arbitration clauses. In 1987, the United States Supreme Court in Shearson/American Express v McMahon, 482 U.S. 220 (1987), held that pre-dispute arbitration clause are enforceable and found that the Federal Arbitration Act established a federal policy favoring arbitration. Since that decision, almost all individual cases involving customer disputes with brokerage firms are arbitrated because brokerage firms require (i.e. not negotiable) customers to agree to a pre-dispute arbitration clause (i.e. mandatory or forced arbitration)at the time that every account is opened. Furthermore, in 2007, the two primary securities self-regulatory organizations, (National Association of Securities Dealers (“NASD”) and New York Stock Exchange (“NYSE”), that sponsored the primary securities arbitration forums merged into one entity, FINRA. As a result, the vast majority of securities disputes now are resolved exclusively in FINRA arbitrations.
For years, critics of the securities arbitration process have claimed that it is skewed in favor of the securities industry and is fundamentally unfair to consumers. One of the main criticisms has been that the arbitration rules require that that there be one arbitrator currently working in the securities industries (i.e. industry arbitrator) sitting on the three person arbitration panels deciding cases. Critics of the requirement have long believed that industry arbitrator negatively impacts the arbitration outcomes. Statistics tend to support the criticism. For example, in 2005, a study of was conducted which analyzed the outcomes of over 14,000 securities arbitrations filed between 1995 and 2004 and that were resolved by arbitration panels in formal hearings (i.e. cases that did not settle). The results demonstrated that individual investors who bring claims against brokerage firms and prevail can expect to recover only a small percentage of damages claimed. Furthermore, FINRA’s statistics for years show that in cases that were decided by arbitration panels between 2005 and 2010, Claimants prevailed only 37%- 46% of the time.
The negative sentiment described above only grew in 2008 when America suffered the largest economic downturn since the Great Depression. Most of the blame for the collapse was placed at the feet of Wall Street. As a result, political pressure grew to reform the way in which Wall Street conducted business and on July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”). The Dodd-Frank Act is the broadest sweeping legislative reform to the securities industry since 1934 and requires several federal agencies including the Securities Exchange Commission (SEC) to consider and implement 243 rulemakings and to conduct 67 studies all designed to protect consumers.
This article will discuss two key provisions in the Dodd-Frank Act, sections 913 and 921, which in coming months may impact the legal standard imposed on financial advisors providing personalized investment advice as well as the continued viability of investors being forced through pre-dispute arbitration clauses to resolve their disputes in arbitration. As described in more detail below, section 913 of the Dodd-Frank Act in part, requires the SEC by January 21, 2011 to release the finding of its study on whether the SEC should impose a uniform fiduciary standard on all financial advisors who render personalized investment advice. Section 921 of the Dodd-Frank Act directs the SEC to investigate the use of mandatory pre-dispute arbitration and if it finds that the practice runs against the public interest or does not further the protection of investors, the SEC may limit or prohibit its use. Finally, this article will identify and discuss common legal theories brought by investors in FINRA arbitrations.
II. Section 913 of the Dodd-Frank Act: The study of whether to impose a uniform fiduciary standard on all financial professionals rendering personalized investment advice.
Many consumers hire financial professionals for their expertise and expect to receive competent advice that is in their best interest. After all, who would entrust their hard-earned nest egg to someone that is not trustworthy? Wall Street firms spend millions of advertising dollars each year enticing new customers, and reaffirming for their existing customers, to put complete faith and trust in their broker’s investment knowledge and expertise. From a legal perspective, of course, it would logically follow that these same firms accept the fact that they are fiduciaries and always place their clients’ interests first, right? Not so fast.
Until the recent passing of the Dodd-Frank Act, these same firms that depict their financial advisors as the equivalent of a trusted family member feverishly act behind the scenes to deny and repudiate their status as a fiduciary. Since the 1930’s and 1940’s, the last time there has been major securities reform, Wall Street has been able to create different standards of care among financial advisors who give personalized investment advice – i.e. the suitability standard and the fiduciary standard. The suitability standard requires only that financial advisors working for Wall Street firms (“stockbrokers” or “registered representatives”) recommend investments that are suitable (or reasonable under the circumstances) for its customers. On the other hand, advisors such as fee-only registered investment advisors (“investment advisors”), who generally do not work for Wall Street firms are held to the more stringent statutory fiduciary standard imposed by the Investment Advisors Act of 1940.
Investment advisors are required to always put their clients’ interests first. Investment advisors are also statutorily required to disclose all actual and potential conflicts of interest. In contrast, according to Wall Street firms, the suitability standard does not require that they or their brokers put their client’s interest first, or that they provide disclosure of conflicts, even when silence could be detrimental to its clients. By being held to merely the standard of having “reasonable grounds” for a recommendation, Wall Street is given cover to argue that it need not disclose conflicts of interest; it need not reveal all compensation earned on a trade; it need not monitor a customer’s portfolio after the investment is made; and that neither the Wall Street firms, nor their brokers, have the obligation to fulfill most of the other duties that would assuredly be within the scope of the obligations owed to a customer that has entrusted a fiduciary to make or assist with their investments.
Section 913 of the Dodd-Frank Act requires that the Securities Exchange Commission (“SEC”) complete a study by the end of January 2011 to determine whether the fiduciary standard, which requires that clients’ interest comes first, should be applied to all financial professionals providing individualized investment advice. In essence the SEC has the power to create a federal fiduciary standard that could limit or altogether eliminate the different standards imposed on a state-by-state basis.
From the Wall Street industry groups’ point of view, requiring that stockbrokers adhere to a fiduciary standard will unnecessarily increase compliance costs. Further, in their comment letters to the SEC, they also warned that investors stand to lose if more barriers are placed upon firms when recommending that an investor purchase securities from the firms’ own inventories and will prevent firms from selling consumers proprietary investment products.
From the consumers’ point of view, they already trust their financial advisors and are not aware that they could be subjected to different legal standards. Uniformity would help simplify the process and would provide consumers with what they already expect. To demonstrate why the SEC should impose the uniform fiduciary standard, Opinion Research Corp./Infogroup conducted a consumer survey to test whether consumers, in fact, know the difference between investment advisors, financial advisors, stockbrokers and/or insurance agents. According to a September 15, 2010 article in InvestmentNews entitled Most Investors Think Brokers Are Fiduciaries, Survey Says, among 1,319 investors it surveyed, 91% believe that a financial advisor and investment advisor should follow the same investor protection rules, and 96% favor applying those uniform rules to insurance agents as well. In addition, 97% said that financial professionals should put investor interests ahead of their own and disclose fees and conflicts of interest.
The study also found that more than half of investors are confused about the standards of care that different advisors must meet, and that at least 60% said that they assume that insurance agents and stockbrokers are already held to the fiduciary duty standard.
Over the years, the confusion caused by the different standards of care has been felt in the courtroom as well. Throughout the country, federal and state courts have drawn a distinction between stockbrokers and investment advisors even though both render personalized investment advice. Also, courts have been divided on the issue of whether financial advisors owe a fiduciary duty to customers of Wall Street firms. Unfortunately, a large reason for these legal inconsistencies stems from the fact that many courts accepted Wall Street’s argument that the type of account (discretionary vs. non-discretionary) was the sole determining factor in whether a fiduciary or trust relationship existed between the broker and a client. Most courts have consistently held that stockbrokers owe a fiduciary duty to a customer where the broker has discretion to make trades without asking the client’s permission first (i.e. discretionary account.) Courts have been more divided on the issue of whether financial advisors owe a fiduciary duty when the advisor is required to obtain client approval before making a trade (i.e. non-discretionary).
Regardless, the niceties of this legal debate are completely lost on the investing public, who view discretionary and non-discretionary accounts as a distinction without a difference. Stockbrokers are highly motivated and actively schooled by Wall Street to cultivate their clients’ trust and allegiance, and clients have powerful incentives to believe that such advisors are trustworthy and acting solely in the client’s best interests. Obtaining a client’s trust and confidence, and convincing the client that he or she should rely upon the investment advice given, is at the heart of the broker/client relationship. If a broker fails to live up to the caricature of trusted advisor portrayed in the firm’s marketing materials, the retail investor is shocked to find that their trust was misplaced, with the broker claiming in essence, that they were merely an “order taker,” with nothing other than the most nominal obligation to make sure an investment recommendation was “suitable.”
As stated above, the SEC is required to release the results of its study on January 21, 2011. These results will be discussed in more detail at the ABA Mid-Year Meeting presentation.
III. Section 921 of the Dodd-Frank Act: The debate over whether requiring aggrieved investors to arbitrate their claims.
As stated above, the Dodd-Frank Act directs the SEC to examine mandatory pre-dispute arbitration to determine whether the practice runs against the public interest and does not further the protection of investors. The language does not explicitly tell the SEC how to go about this task or call for a formal study but rather directs that if it finds that mandatory pre-dispute arbitration runs against the public interest or does not further the protection of investors, it may limit or prohibit its use.
The SEC is currently soliciting input on mandatory arbitration in securities-related disputes. For those interested in commenting on what, if any, actions the SEC should take with regard to mandatory pre-dispute arbitration in securities industry disputes, the SEC website (www.sec.gov) provides a link to send the agency your comments.
Based on the comments received so far, it appears that there is an even split between those in favor of keeping the practice of mandatory arbitration and those calling for its demise.
Advocates of giving investors the choice to resolve their disputes in court point to the inadequacies of the arbitration process and the fact the American public has a constitutional right to resolve disputes in a court of law. One of the fundamental complaints about the arbitration process is that FINRA is a self-regulatory organization that is directed by the SEC to regulate the securities industry. Therefore, in order to be licensed to purchase or sell securities for the investing public, a securities brokerage firm must be a member of FINRA. In other words, much of FINRA’s funding comes from its members, the securities industry. Investor advocates argue that the FINRA arbitration forum is, therefore, biased in favor of the securities industry.
Another criticism of arbitration is that arbitral awards may not serve as precedent in future cases, and because securities disputes are for the most part decided in the arbitral forum, case law in the area has not developed since 1987 when the U.S. Supreme issued its opinion in Shearson/American Express v McMahon, 482 U.S. 220 (1987).
Those in favor of mandatory arbitration defend the practice by pointing out that arbitration serves a valuable function for both sides that avoids the cost and delay of court. With regard to defending the fairness of the arbitration forum, proponents of the system point to recent changes by FINRA that will make the forum fairer for investors.
The main improvement cited by advocates of arbitration is the elimination of the industry arbitrator. In 2008, FINRA launched a Public Arbitrator Pilot Program that permitted investors in eligible cases to have their case decided by a panel of three public arbitrators instead of two public arbitrators and one industry arbitrator. In 2010, FINRA proposed to the SEC that the pilot program be made permanent. The SEC has not yet approved FINRA’s proposal but is expected to approve FINRA’s proposal within the next few weeks.
IV. Common Claims in Arbitration
Arbitration is a final, and binding resolution of a dispute by a person(s) called an “arbitrator” or “neutral”. Claimants initiate the arbitration process by filing a Statement of Claim that details the factual background, allegations of wrongdoing, and damages. Respondents set out their defenses and counterclaims in a Statement of Answer. Both parties participate in the ranking and striking of proposed arbitrators. The arbitration process is similar to civil litigation in that the parties engage in discovery, motion practice and trials or final evidentiary hearings. The final hearing format mirrors that of civil trials. Claimants and Respondents make opening statements, Claimants put on their case in chief, Respondents put on their case in chief and the parties each make closing statements. Arbitration panels are not required to provide reasoned awards and arbitration ruling have limited precedential value.
The following claims are frequently seen in securities arbitrations:
A suitability claim is one of the most common customer claims made in FINRA arbitrations. Suitability claims are often based on violations of the rules that establish suitability guidelines. Rule 405 of the New York Stock Exchange provides that a firm must perform due diligence to learn the essential facts and background of their customers. This is the “Know Your Customer” rule. NASD Rule 2310, often referred to as the “Suitability Rule”, mirrors the purpose of NYSE Rule 405. Rule 2310 provides:
(a) In recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.
(b) Prior to the execution of a transaction recommended to a non-institutional customer, other than transactions with customers where investments are limited to money market mutual funds, a member shall make reasonable efforts to obtain information concerning:
The customer’s financial status;
The customer’s tax status;
The customer’s investment objectives; and
Such other information used or considered to be reasonable by such member or registered representative in making recommendations to the customer.
The Suitability Rule applies when there is a “recommendation” by the broker. Mere order takers have limited suitability obligations. The key to the recommendation requirement is whether the broker expressed a belief that the transaction was something the customer should make. A confirmation slip marked “solicited” is usually good evidence of a recommended transaction.
Negligence claims are based on a duty owed to the customer and a breach of that duty by the broker or firm. Negligence claims are essentially broker malpractice claims and require no showing of intent to harm the client. In a broker negligence case, the customer must show that their broker’s actions fell below the standard of care. The standard of care is generally established by federal and state securities laws, by common law, and by self-regulatory rules as promulgated by the NASD and the NYSE.
Material Misrepresentations or Omissions
Brokerage firms and their brokers can be held liable if they misrepresent material facts or if they omit material facts to an investor about the purchase or sale of an investment. Often the misrepresentations or omissions disguise the risk associated with a particular investment. Typically, a client must have reasonably relied on the broker’s misrepresentation or omission and must have made the decision to buy or sell the security based on the broker’s conduct.
Breach of Fiduciary Duty
Brokerage firms may owe a fiduciary duty to their customers. In these circumstances, the firm and broker occupy positions of trust and confidence, and owe the highest degree of loyalty and fidelity to the customer. The fiduciary duty requires a brokerage firm to make full and fair disclosure of all material facts and to place the interests of the customer ahead of the interests of the firm or the broker. The fiduciary duty also requires brokerage firms to supervise and monitor the activities of the firm’s employees, perform pre-sale due diligence and after-sale monitoring of investments.
Churning claims involve account activity that exceeds the investment profile and risk tolerance of the customer. Brokers often churn accounts in order to generate higher commissions from the unnecessary purchases and sales of products. In the typical churning case, the customer must prove:
1) That the broker controlled the account.
2) That the trading was excessive in light of the client’s investment objectives and
3) That the broker intended to defraud the customer or acted willfully or recklessly. Two common methods for determining the excessive trading element are turnover rate and cost to equity. The turnover rate is the annualized total dollar amount of purchases during a time period divided by the average account equity. The rule of thumb concerning turnover is often referred to as the “2-4-6 Rule.” This guideline views annual turnover rates as follows: two times in a year is suggestive of excessive trading; four times in a year is indicative of excessive trading; and six times in a year is conclusive of excessive trading. The cost to equity or “break even” analysis is the annualized cost of trading (including commissions, margin interest, and other expenses) divided by the average equity. The result is the percentage of return the account would have to earn before it returned any profit to the investor. Whether a particular turnover rate or cost-to-equity ratio will constitute churning depends upon the customer’s investment objectives and experience and the level of control exercised by the broker.
A fundamental principle of investment strategy is diversification. A diverse portfolio can help limit risk and mitigate losses. A sufficiently diverse investment portfolio can protect individual investors from sustaining extreme losses as a result of common market fluctuations while still allowing for profits from gains in discrete stocks, market sectors, or asset classes. A diversified portfolio often includes investments in different companies, different market sectors, and different types of investments. Over concentration claims are fact dependent and the investor’s risk tolerance and investment objectives must be analyzed in order to establish a viable claim.
Failure to Supervise
Financial and securities brokerage firms have a legal duty to supervise their brokers and their brokers’ recommendations to clients to ensure compliance with the rules of the securities industry. When an individual broker is negligent or acts in an unlawful manner against the interests of the client and that client suffers damages, the firm may be held liable for the investor’s losses. New York Stock Exchange Rule 405(b) requires a brokerage firm to: “Supervise diligently all accounts handled by registered representatives of the organization.” Proper supervision in the securities industry is mandatory. Firms must create, maintain and enforce a plan that will supervise the day-to-day activities of their workforce.
A customer who purchases securities may pay for the securities in full or may borrow part of the purchase price from his or her securities firm. If the customer chooses to borrow funds from a brokerage firm, the customer must open a margin account with the firm. The portion of the purchase price that the customer must deposit is called margin and is the customer’s initial equity in the account. The loan from the firm is secured by the securities that are purchased by the customer. Customers generally use margin to leverage their investments and increase their purchasing power. At the same time, customers who trade securities on margin incur the potential for greater losses. When the margin ratio in the account exceeds the requirements by the firm, the customer is also susceptible to a margin call which could force the sale of the customer’s securities. Using margin to increase buying power is not appropriate for everyone. The broker must disclose the benefits as well as the risks of trading in a margin account before making any trades in the account.
Unauthorized Trading/Failure to Execute
Two types of customer accounts exist in the retail brokerage firm business. The first account, known as a discretionary account permits a brokerage firm to trade within the account without seeking client approval before making the trade. The trading of a discretionary account must be done within the guidelines established by the client and the firm. The second type of account is a non-discretionary account. If a broker purchases or sells a security in an investor’s account without that investor’s approval the broker has engaged in unauthorized trading. A non-discretionary account requires customer contact and consent prior to the execution of each and every trade. A failure to execute claim is based on an order placed by the client and the broker’s failure to timely execute the order. The failure may be either an order to sell or purchase. These claims are often difficult to prove without written or recorded orders from the customer.
Blue Sky Violations
Blue sky laws regulate broker-dealers, securities, brokers, investment advisors and financial planners. They are designed to protect investors from securities fraud. For the most part, these laws require the registration of securities offerings, sales, brokers, investment advisors, brokerage firms and anyone who sells securities. Each state has a Securities Commission that is in charge of overseeing their state’s blue sky laws. To have a successful blue sky law claim, the customer must show that they purchased an unregistered security and, that the brokerage firm wasn’t registered in their state, or that there was another violation of the applicable blue sky law.
The investor protection provisions of the Dodd-Frank Act could bring monumental change to the world of securities arbitrations. While securities allegations and claims are likely to remain the same, Sections 913 and 921 could very well end mandatory arbitration and increase broker duties substantially. Such changes would have an impact on the number of arbitrations filed and the strategies used to defend securities claims. Also, if fiduciary duties are imposed on all financial advisors, we may experience a sea change in investor protection. However, the full impact of the Dodd-Frank Act will probably evolve over time as regulators determine the appropriate framework for its implementation.