Terra Extraneus

Investment News posted a story by the Associated Press reporting a trend in which the investor retreats from RIAs and traditional brokers, and then goes to an online source to learn about money managers. Next, the investor can select one or a group of professional money managers to track. Finally, the investor opens an account and in the account the same trades made by the manager are made in the investor’s account. The fees for this service are about the same as the fees for mutual funds.

While this type of program might be better than no advice at all, and it might be better than searching Schwab’s or Fidelity’s website for user friendly advice, it is hard to see how it would compare favorably to the services of RIAs, brokers or CPAs. Admittedly, finding a qualified RIA, broker or CPA is not an easy chore.

Sitting in a room with a human the demeanor of whom you can evaluate along with an evaluation of their advice is something you cannot do with a website. As wonderful as the web is, it is artificial and regardless of the simulation, it is not yet intelligent. Risk assessment, the core value of financial advice, is sometimes as much a product of experience as it is knowledge.

The essential flaw in the advice of many RIAs, brokers and market predicting CPAs is usually inadequate risk analysis. The opportunity to remotely track money managers and copy their trades does not actually address this deficit, but merely wishes it away. It also assumes that the internet window is sufficiently transparent to permit assessment of character and philosophy without interpersonal contact.

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Carmelo Anthony, an NBA star with an $80 million dollar five year deal, according to the regular news media, found himself in the unenviable position of suing his financial manager, Larry Harmon. The news media reporting of the basic facts of the case has been garbled.

But, somehow the case got into federal court in California. The federal court dismissed the case with leave to amend the Complaint, a “do over,” in technical terms. The seven page opinion was like a walk down memory lane for me. For Mr. Anthony, it was no doubt bewildering.

When I started practicing law, we were still filing and arguing demurrers to petitions. Demurrers to petitions were pleadings that argued that the petition did not state a cause of action either because it failed to plead sufficient facts or because it failed to plead facts that under applicable law constituted an actionable wrong. Demurrers to petitions were abolished when notice pleadings was adopted. So, too, were gone the weekly trips to the courthouse to argue demurrers to petitions.

But, Mr. Anthony has managed to make a seven page opinion in effect granting a demurrer to a petition (the federal court term is “complaint” but they are essentially the same in modern practice) a national headline. Will judges all over America go to work microscopically analyzing complaints (or petitions removed from state court)?

It will occur only if the judges were not around during the demurrer era. Some judges liked the tedium and the gatekeeper role, but most found that it detracted from their real work, deciding cases, and buried them in poorly developed or untested facts and legal theories. Also, some wrongs cannot be articulated with the precision required in court until after considerable discovery. Wrongdoers and confusion usually are bedfellows, even if inadvertently so. Judges are usually keenly aware of this.

For non-lawyers and non-judges, if the goal is to “clean up” the courthouse and deter frivolous lawsuits, raising the filing fees will do more. The real problem, if there is one, is that as a society we spend less than 1% of governmental revenues on the court system, a historical fact that has not changed in a life time. With better funded courts and more judges, especially on the state trial level, judges would have no trouble managing the system.

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The September 24 ,2009 warning by FINRA about leveraged and inverse ETFs was a bit annoying. If FINRA has to warn about it, should not there be new suitability rulemaking to go with it aimed at these products?

Even the explanation by FINRA of what these products are lacks clarity for the people FINRA is trying to warn. Of even more concern, however, is that these products, FINRA believes, are especially apt to act erratically in volatile markets.

FINRA’s explanation of these products contains nicknames like “short funds” and “ultra short funds,” as if the investor reading the alert that did not understand the more formal name might get something out of the less formal. Of course, FINRA has to start somewhere, and the name is the most logical place to start. But, what else is the investor likely to get beyond the names? Will the investor really understand the nature of these products and their real risks?

These products should probably be classified by FINRA for suitability purposes as “speculative,” if FINRA’s warning is to have any real meaning. That would go a long way toward diverting them from the unsophisticated. FINRA could also declare them unsuitable for retirement accounts. FINRA could also preclude margin account purchases of these products, or limit margin account purchases to margin accounts with an actual marked to market value exceeding one million dollars.

Unless FINRA begins these types of protective rule implementations, FINRA will always be regulating after the losses instead of preventing them.

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Associated persons (a/k/a “financial advisors,” stockbrokers, etc.) should be wary of FINRA’s new Rule 13806 which provides for a single arbitrator in promissory note cases. While the single arbitrator may be fine for default cases, where the associated persons plans to make no defense and files no answer, rarely are single arbitrators desirable in contentious employment cases of any kind. Invariably, single arbitrators rarely have the courage on their own to do more than do a Solomon - like “split the baby” Award. Worse, too often, the single arbitrator is so aligned with the industry that even public policies designed to protect ALL employees are simply disregarded. FINRA tried to avoid the latter by restricting single arbitrator choices to panelists qualified to hear discrimination cases. However, anyone caught in this system should be wary until the system statiscally verifies its lack of imbalance in favor of the industry.

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The new FINRA statistics are always fascinating. While filings are up for 2008, “82%” FINRA says, that is an 82% increase over the fourth lowest number of new case filings since 1994. The lowest since 1994 was in 2007 at 3,238. FINRA is estimating new case filings in 2009 will eventually reach 7,750, even though as of June the new filings had not reached 4,000. Thus, FINRA is predicting for 2009 the fourth highest number of new case filings since 1994.

Why did the number of new case filing in 2007 drop so drastically? Was it because of strong market performance? Was it because of upgraded and determined compliance by the securities broker dealers? Was it because the legal community decided to leave these types of cases to specialists? Was it because the legal community thought that the system was rigged (i.e., the controversy over industry panel members and other disputes) and stopped filing cases?

We have heard anecdotal reports, and seen some news media reports, suggesting that all of these might be true, or might be the perception of at least some participants. If these, in whole or in part, are true, or perceived as true, then FINRA’s projection of new case filings for 2009 may be too high.

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In Colorado, at least, it might matter. In Dish Network v Altomari (Colo. Ct. App. June 25, 2009), the question was whether the employee that supervised some people, probably a sales staff, was in “management.” If the employee was in management, then under the Colorado non-compete statute, a non-compete against the employee was enforceable. The Court of Appeals reversed the trial court and held the employee was in management.

The term “management” is not defined in the Colorado statute. However, it is pretty clear the court is confused about what constitutes “management.” The only employees in “management” are those who can bind the company or otherwise decide company policy, typically corporate officers and directors. That would be a logical purpose of the statute. Applying the statute to middle or lower tier supervisors turns the statute from a fair allocation of business risk to a draconian labor control tool.

Of course, will Financial Advisors in Colorado with titles like “Vice President” or “Director” once again face non-compete risks when they trade jobs? Protocol firms may not be tempted but many will be in the is shaky economy. Financial Advisors in Colorado should try to wheedle an email or something that indicates they are not in management, or obtain a page from a firm policy manual that says something similar.

(Hat Tip: Professor Ross Runkel’s employment law summaries)

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The federal government is prosecuting far fewer fraudulent stock schemes than eight years ago, according to Eric Lichtblau of the San Diego Union Tribune, in December. Darla Mercado of Investment News reported today that the Attorney General of Massachusetts concluded her prosecution of Goldman Sachs by an agreed fine of $60 million on a neither admit nor deny basis. The Goldman Sachs fine was for Goldman Sach’s role in securitizing subprime-mortgage loans.

While the fine is not insubstantial, the cost of the subprime mortgage collapse has been astronomically more than $60 million. The combined lack of focus on federal stock prosecutions and the devolution to state by state enforcement apparently may have been a factor in bringing about a pervasive lack of securities industry standards. With recent statutory limitations on stock class actions and the general tort reform mood of the country, the ability of the average victim to enforce securities law violations has also been reduced.

With less to fear from the federal government, the fragmentary enforcement available from the state level, and the diminished capacity of the private class action bar, the securities industry may have gotten its wish. But, maybe it should have been frightened of getting it.

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How did Bernie Madoff, the hands-down all-time winner of the title “world’s greatest thief,” get away for so many years with bilking so many investors out of so many billions of dollars?

Madoff awaits sentencing after pleading guilty to 11 felony counts in a Ponzi scheme by which he swindled investors out of $65 billion. Inmate 61727-054 has settled into his new home: a 7½ x 8-foot cinder block cell at the Metropolitan Correction Center in New York City.

How could Madoff get away with such a massive fraud for so long? Don’t we have regulatory mechanisms in place to protect investors against crooked brokers and investment advisors? Yes we do — sort of. If the Bernie Madoff super-con has provoked your ire, how do you react when you learn that one of the people entrusted with preventing such skullduggery was – wait for it – Bernie Madoff. Keep reading.

The Securities and Exchange Commission is the agency charged with enforcing federal securities laws. The SEC was established in 1934 in response to the 1929 crash and the Great Depression that followed. The SEC makes sure that public companies disclose information that investors have a right to know. It also brings enforcement actions against brokers, dealers and advisors who violate securities laws.

However, to a great extent, the SEC allows the securities industry to regulate itself. Come again? That’s right, our first line of defense to protect investors against dishonest brokers and broker-dealers is for the brokers to regulate themselves.

FINRA (the Financial Industry Regulatory Authority) is the self-regulatory organization entrusted by the SEC with making sure that its member brokerage firms and their registered reps follow the law. FINRA can initiate disciplinary actions against its erring members, and also, unhappy customers may file complaints with FINRA against their brokers, which are resolved through arbitration.

By the way, if you have never heard of FINRA, you probably have heard of its predecessor: the National Association of Securities Dealers (NASD). In 2007, the NASD became FINRA and took over enforcement of all major U.S. stock exchanges. So how well does FINRA do at keeping its own members in the financial sector in line? That is, how is FINRA doing besides failing to uncover the biggest swindle in the history of the industry?

According to the Wall Street Journal, in 2008 FINRA levied fines against financial firms totaling $40 million. $40 million? That’s a miniscule sum compared to the trillions being managed by the 5,000 brokerage firms, 173,000 branch offices and 659,000 registered reps that FINRA oversees.

In addition, customers filed about 5,000 arbitration cases with FINRA in 2008. The most common complaints were breach of fiduciary duty, misrepresentation, breach of contract and negligence. However, less than 500 arbitrations in 2008 survived the process all the way to an actual hearing and decision, and less than half of them (42%) resulted in an award for the claimant. About 2,000 more cases were settled or mediated.

To the securities industry, a few million dollars in fines and a couple of hundred arbitration awards is the equivalent of an occasional “traffic ticket.” The industry merely budgets these minor inconveniences as part of the cost of doing business.

And how does Madoff figure into this discussion? Well, believe it or not, Madoff is a former chairman of the NASD’s board of directors, a former member of the NASD board of governors, and a former chairman of Nasdaq, the stock exchange the NASD regulated. In other words, to put it in the simplest possible terms, while Madoff was stealing billions of dollars from unwitting investors, he was also serving as one of the top officials entrusted with making sure brokers didn’t get away with such things. Wall Street, we have a problem.

Dallas money manager Gary D. Halbert writes: “How could regulators have missed this one? Oddly, Madoff appears to have operated below the radar screens of the SEC and various other regulatory agencies for many years. Perhaps this was because of Madoff’s very high Wall Street profile and his service as co-founder, board chairman and governor of the NASDAQ for several years in the late 1980s and early 1990s.”

Halbert continues:

The SEC said it conducted two inquiries [including a 2007 examination] of Madoff in the last several years and did not find major problems. … I find this baffling! My company, Halbert Wealth Management, is a Registered Investment Advisor with the SEC. We have been through a routine examination by the SEC. Our broker-dealer firm, ProFutures Financial Group, has been through multiple routine examinations by the NASD, and more recently FINRA … I can tell you that these routine regulatory examinations – at least among smaller firms like mine – are rigorous. They typically have 2-3 examiners in our offices for up to two weeks at a time looking at all of our books … If my company was running a Ponzi Scheme, or stealing customer monies, I feel confident that the regulators would have caught us upon the next regularly scheduled examination. … Frankly, I have NO CLUE how the SEC failed to discover Madoff’s giant Ponzi Scheme in its various examinations.

Halbert’s observation underscores a frequent criticism of SEC and FINRA enforcement: that the agencies go after small fish to keep up appearances, while failing to uncover large-scale wrongdoing perpetrated by the major players. Madoff was one of the biggest, and he went undetected for years.

As I said, under our current system, our first line of defense to protect investors against dishonest brokers and broker-dealers is for the brokers to regulate themselves. That means that in the case of Bernie Madoff, we have been trusting history’s all-time greatest thief to keep himself honest. That’s not working. New SEC chief Mary Schapiro says a crackdown is coming. “The world has changed dramatically in the last year,” Schapiro recently told Congress. “There will be no sacred cows.”

Given recent headlines, tough talk is to be expected. Tough action is another matter. We’ll believe it when we see it.

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The investment banks, the wirehouses, and the large broker-dealers, which have all but ceased to exist, had a love - hate relationship with “at will” employment law. Even the late and great Merrill Lynch, once the “white hats” in the industry, struggled with it from time to time. In the 2000s, however, Merrill Lynch seemed to lead the industry toward a reasonable set of protocols by which stock brokers, registered representatives could change jobs. Merrill Lynch, at the end of its corporate life, would not engage in retaliatory litigation and disdained forfeitures of earned stock or compensation.

It remains to be seen how industry survivors will fashion their employment policies going forward. However, California courts have recently indicated a no nonsense attitude toward employment contracts containing non-compete clauses and California has always treated forfeitures with disdain. Texas, likewise, seems to have affirmed its own legal, if not moral, prohibition of anti-competitive provisions that go further than necessary to protect legitimate employer interests, such as forfeitures of earned stock or compensation.

The Texas Court of Appeals in Corpus Christi issued its 2009 opinion in Valley Diagnostic Clinic v Dougherty. While this was a dispute between a doctor and his former clinic, in which the clinic sought to forfeit earned but deferred compensation, the principles are the same for other industries. Just as the Texas State Board of Medical Examiners places certain limits on enforcement of these types of clauses, so, too, does FINRA and state regulators (even if they are not identical). Over shadowing that, however, is that the public policy of Texas, like many other states, deems “a compensation provision made only in exchange for a non-compete promise…precisely the sort of restraint of trade that Texas law prohibits.”

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The New York Times reported on January 28, 2009 that JP Morgan conducted a “wide ranging review” of its hedge fund exposure. JP Morgan asked Bernard L. Madoff’s funds questions and did not like the answers. JP Morgan withdrew the money it invested in 2008, prior to the implosion caused by the discovery that Madoff was the greatest Ponzi-scheme offeror in history. But, JP Morgan did not tell its own customers about its experience with the Madoff-linked funds.

No doubt the personnel at JP Morgan that conducted the review, got the answers from the Madoff-linked funds, decided the answers were insufficient, and recommended fund withdrawals, rather than being given a corporate gold star by JP Morgan, will end up being used as cannon fodder while JP Morgan management tries to defend itself against its own unhappy customers that believe JP Morgan should have alerted them, too. JP Morgan will no doubt claim that there was a Chinese wall between its internal corporate investment advisors and its external fund managers. The managers of the funds of JP Morgan customers will no doubt claim they did not get the word from the internal corporate advisors.

The New York Times reported that JP Morgan got itself out of the Madoff-linked funds when the funds were reported to be up five percent while the broad market was down thirty percent. Also, the news report indicated that Madoff accounts were held at JP Morgan, in other words, Madoff was a bank customer, too. Was JP Morgan able to use what it learned from those accounts to protect itself but unwilling, or unable, to use that information to protect all of its customers?

It will be interesting to see whether JP Morgan gets sued in a claw back claim by the regulators. After all, the money JP Morgan withdrew was arguably not their money, but the money of some other dupe.

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