Terra Extraneus

One of my earlier experiences with advertising material regulation was the time the NASD refused to approve an advertisement by a registered representative that contained a cartoon with a caption that read “We put the boots on the bull.” The cartoon displayed a Texas longhorn wearing boots. The NASD’s refusal was that they could not determine from the cartoon and caption what expertise the registered representative was claiming. In other words, in past eras, NASD advertising materials regulation has largely been arbitrary and without substantive principles to guide it. The NASD seemed to have no trouble in that same era with Merrill Lynch’s logo which incorporated a bull (but not a Texas longhorn).

FINRA Regulatory Notice 08-27 seems to focus on the advertising materials created by ghost writers and professional advertisers designed to give the appearance of credentials based on book writing, article writing, and newsletters. Of course, while this might be a serious subject, it still does not address the real issue: what constitutes a “credential” for a registered representative?

The main worry of the FINRA Regulatory Notice seems to be that the ghost written materials imply the registered representative is the author “and therefore an expert.” I hate to break this too harshly to FINRA, but every registered representative claims to be an “expert.” What customer wants a registered representative that is not an “expert?” Of course, making the claim by creating false credentials or false marketing materials is fraudulent. Nevertheless, because the industry refused to definitively define what constituted a “credential,” and continues that proud tradition, claiming to be an expert will continue.

By the way, if one is searching for a ghost writer to create marketing materials for financial services to individuals, I have had the privilege to know a couple of the best. The disclaimer included in their materials that the financial executive is not the sole author of the materials is often overlooked by the prospective customer that wants to hear what they want to hear.

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As an Oklahoma based trial lawyer, I do not have the luxury of a continuous stream of cases all in the same genre or even area of law. Largely originating on one of the three coasts (including the Gulf Coast), cases usually come in waves. I just completed a three year group of 41 cases, ten of which were tried, against Goldman Sachs & Company. This particular wave of cases was actually the second tidal surge because during the three years prior to the just concluded three years, I was counsel against Goldman Sachs in a predecessor wave of cases.

Goldman Sachs manages its exposure somewhat idiosyncratically and not quite like the other wire houses or other member firms in the securities industry. For instance, Goldman Sachs is far more concerned about its image than it is winning or losing, or even the economics of any particular case. Because the securities industry effectively gags its associated persons thus creating a conspiracy of silence, Goldman Sachs can litigate endlessly with associated persons and face little risk that the image it jealously guards will be tarnished by inconvenient media exposure.

The news media has no effective means of penetrating this conspiracy of silence, because no member firm is going to allow its associated persons to speak freely to the media, even about other member firms (or previous employers). Also, one has to wonder if the media will even try to break the code of silence, because of the possible back lash by one or more member firms.

Abusive personnel practices have been a hall mark of about half the securities industry, and avoided by the other half. Goldman Sachs’ abuse of registered representatives was largely the result of institutional errors made when investment bankers attempted to “fix” the firm’s “brokerage” and “advisory” personal wealth management business. It reminded me of watching a newly minted teenage driver. You constantly have to remind them at first to look back over their shoulder while backing out of the driveway. Goldman Sachs was so intent upon socially engineering the lives of its registered representatives that it back over half of them.

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Errors and omissions insurance policies for registered representatives and broker-dealers have been offered at different times by different companies and usually, quickly withdrawn from the market. One of the companies that has stayed in the market longer than most has been AIG / National Union.

But, as demonstrated in a consolidated case, Ryan v National Union, United States District Court, District of Connecticut, AIG / National Union has a strange way of handling these cases.

First, the policy excluded coverage for discretionary accounts or the exercise of discretion. Second, the policy excluded outside activities that included “any entity other than the broker-dealer.” Third, the policy had a relatively short “tail,” in that it excluded coverage for acts pre-dating the policy effective dates and additional time coverage in the “tail” provision.

In other words, about the only thing covered, if the insurance company had its way, would be claims arising during the policy period resulting from acts during the policy period in brokerage accounts (not fee based advisory accounts in which discretion was exercised rightly or wrongly), which typically would include only the old fashioned stock broker, commission and sales of securities. In the Ryan case, the federal court held that the exclusions did not exclude all possible claims that might be implicated by the pleadings in the arbitration proceedings, and therefore there was a duty to defend all the claims in the arbitration proceedings.

It is sad that the AIG / National Union product has become so prevalent among the few who can afford or do buy insurance. A better product issued by a company that was more concerned about its insureds would probably lead to a broader market. A broader coverage market would lead to lower premiums because there would be more buyers among which to spread the risks.

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Karen Donovan at Registered Rep reported the recent study issued by a Washington, DC law firm that concluded that fines and sanctions were less when the enforcement issues were litigated than when imposed by settling with FINRA (“Financial Industry Regulatory Authority”). FINRA, according to Donovan, rebutted the study by merely sloughing it off as a lawyer’s marketing dream.

I have not done a study. Indeed, the study that was issued by the law firm reported by Registered Representative only looked at 55 panel decisions from June 2006 through June 2007. That means the sweep of time was not considered and it means the recent merger of NASD enforcement with NYSE enforcement was not evaluated. In my own experience, there was a difference between the two.

FINRA investigations were usually conducted initially by a compliance professional that was not a trial lawyer and NYSE investigations were often conducted by lawyers, some of whom had enforcement trial experience. Both were relatively easy and fair to deal with prior to filing of a formal enforcement proceeding, and lots of matters could be settled at that stage. Once, however, the formal enforcement action was filed and pending, both were much more difficult.

My own experience has led me to believe the following about enforcement actions generally, and I believe this will generally be true of FINRA enforcement actions.

1. Enforcement proceeding panels usually have at least two industry members on the panel with an enforcement department attorney acting somewhat as an administrative law judge. Industry members are more likely to buffer the harshness of sanctions even in the presence of a stifling enforcement department panelist.

2. The real problem in enforcement actions for the licensed professional is financing the defense if the supervisor or employer will not do so. FINRA has finite resources to allocate, too, but in any given case the licensed professional is out classed. That does not mean that FINRA won’t be tempted to pick off the weak, the sick and aged like any good buffalo hunter, and avoid the bulls and mastodons running with the herd.

3. Most licensed professionals that end up in enforcement proceedings are probably there because of a lapse in integrity, but too many are there for an error in judgment that may not have been their fault. While the industry is retreating from its hand shake business model, that is still the dominate platform. It is a fertile ground for hindsight compliance reviews, customer complaints and disinterring the financial advice from the then prevalent circumstances.

4. Some enforcement actions are brought because of a lack of perspective. A lapse in judgment, i.e., a moment of carelessness, should not result in the same sanctions as intentional or even criminal conduct. If there was no loss attributable to the violative conduct, it almost always means the conduct resulted from unintentional rather than intentional conduct.

These are some, but not all, of the considerations that would create an environment in which enforcement proceedings might result in lesser sanctions or settlements result in harsher sanctions. Clearly, some have nothing to do with the facts of the case. None of them have to do with whether they are studied by lawyers or sociologists.

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The newest published decision regarding U-5 defamation of a terminated registered representative is like an aquarium, for once you can see all of the fish swimming about.

Deborah Galarneau v Merrill Lynch, Pierce Fenner & Smith, Inc. was issued by United States Court of Appeals for the 1st Circuit. The case did not go to industry arbitration because it included a federal discrimination claim. But, the only claim that survived motion practice was the claim that the Form U-5 filed by the employer was defamatory.

The case was tried and decided under the law of the state of Maine, which extended to the employer a qualified privilege, which required the employee to prove that the U-5 entry was false and that the entry was made with actual malice. On appeal, the employer sought 1st Amendment protection for its U-5 filing, but that rather bizarre argument was too little too late.

The 1st Circuit found that the record in the trial court before the jury, indeed, did contain evidence supporting the jury verdict. The employer on four occasions conducted management review of the trading, approved it each time, issued comfort letters to the customer and denied in written responses to regulators that the trading was in anyway improper.

Meanwhile, Ms. Galarneau was summoned to New York by her employer to be interviewed by the Office of the General Counsel. The lesson here for registered representatives: prepare for such an interview. Engage counsel to assist in the preparation, if necessary. Do not take counsel to the interview by the employer (employees that feel they need to take a lawyer to a meeting with their employer should prepare their resume). At the meeting, she allegedly admitted exercising time and price discretion.

But, on her U-5, in addition to listing exercise of time and price discretion as a reason for termination, the employer listed “inappropriate trading,” the same trading approved four times by management, as a reason for termination. The predictable result was that no other firm would consider her.

One of the interesting things contrasted in the opinion was the over reaction by in house counsel. In house counsel rebutted the state regulatory inquiry and then permitted the regulatory response to be contradicted in the U-5. In an awkward effort to defend it, the employer on appeal tried to argue that only after the employer received a report from its outside accounting vendor, Bates Capital, did it become clear that some of the trading was “inappropriate.” Because the employer is the largest broker dealer in the world, it is laughable to think its supervisory accounting systems cannot detect “inappropriate” trading, especially since that trading has to be approved one trade at a time by a local supervisor and further stretches credulity beyond the breaking point to think a multi-billion broker dealer and investment bank must rely on a tiny non-public accounting vendor to learn the truth.

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After the foregoing was posted, Investment News published its news blurb on the opinion which you can find here. While I have great respect for this publication, the title of the article implies the entire judgment was reversed. The article seems to spin the opinion (calling it a “report,” possibly indicating a lack of familiarity with the judicial system) favorably to the employer. However, the $850,000 verdict was sustained. The $2.1 million punitive damages award was reversed. The plaintiff was able to prove actual malice or the verdict for compensatory damages would not have been sustained. The plaintiff was unable to prove the U-5 defamation was intentionally designed to make the plaintiff unemployable, so the punitive damages award was not sustained.

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A new study reported today in On Wall Street confirms what the data on the NASD website has always indicated, that the whole process is tilted toward the brokerages, especially the largest ones. The study reports:

Investors who take on the largest brokerages for big claims — $250,000 or more — recover just 10% to 12% of the amounts for which they ask. For claims of less than $10,000, however, they recovered 30% on average. Against the industry as a whole, the recovery percentage was 34%. For all firms receiving claims greater than $250,000, investors’ recovery percentage was 20%.

According to reporter Tony Chapelle, the study also indicated that in customer claims against the major wirehouses, the customer only wins 38% of the time. That is not surprising given the quality of counsel the major wirehouses can afford, their ongoing influence with panelists they see often, and the sophisitication of inhouse counsel.

What does this mean for registered representatives? It means that things are NOT much better in employment disputes regarding commissions, forfeitures, and similar disputes. It means that arbitration does what it is supposed to do, which is to control the liabilities of the houses, and it means that arbitrators are statistically predictable in their decision making, even if not in every single case.

While I have been able to beat these numbers in my cases, I have often considered that to be more because of the integrity of arbitrators in individual cases rather than trial skills. Nevertheless, any decisional system that favors one side or the other so predictably over time is most assuredly skewed. It should be noted that the numbers shoot up against the smaller houses compared to the major wirehouses.

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Massachusetts is cracking down on brokers and other financial advisors who falsely claim to have special expertise in advising senior citizens on their investments. The new regulations, which take effect June 1, will require that such claims of special credentials must be approved by the Secretary of State. You can learn more about the Massachusetts regulations on the website of Secretary of the Commonwealth William Galvin.

When it comes to investments, senior citizens are where the action is. There are 37 million senior citizens (age 65 and older) in the U.S. today. It is estimated that they control 70% of our nation’s assets. Their median household net worth is $108,885. When you consider that that figure includes home equity, most senior citizens are not wealthy people who can afford to lose lots of money due to poor financial advice. What do you do when you are in your 60s or 70s or 80s and lose your life savings? Few things are more reprehensible than an unscrupulous broker or advisor who recklessly plows through a senior adult’s assets.

To say I am skeptical, is probably an under statement. Massachusetts already licenses insurance agents, registered representatives (securities brokers) and registered investment advisors (as do the NASD/NYSE and the SEC). False or fraudulent representations are already illegal. Investment recommendations that are unsuitable for the elderly or exceed their fragile risk tolerance is already illegal. How will a second license or second level of credentialing help?

Massachusetts would be better off protecting the elderly by restricting surrender charges to two years on products sold to persons after their 70th birthday, prohibiting sales of products to married persons over 70 that do not automatically include a right of survivorship, and doing more to educate licensed persons about and set standards for risk tolerance for persons above the age of 70. For example, people over 70 do not belong in over concentrated portfolios. I often see instances where older and elderly people have been over sold growth and aggressive growth products, sometimes overlapping products, and then the issuer, the broker – dealer or the sales person forget the client exists and does not review positions annually or rebalance the portfolio. Down side risk only seems to matter after a major market correction.

There are too few enforcement actions by states and Massachusetts is hardly leading the way. Most state regulators do not have to commence a forfeiture proceeding against a licensee; the regulator can simply look at a situation, and call the issuer’s general counsel, and advise them they have thirty days to solve the problem. Most issuers will leap at the opportunity to avoid a public announcement of an enforcement action based on sales practice violations practiced on the elderly.

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American public companies and the broker dealers that make markets in their stock needed more protection so the United States Court of Appeals for the 7th Circuit, in Ray v Citigroup Global Markets, Inc., reinterpreted the federal securities laws to include a requirement that disappointed investors must prove not only fraud, but that the fraud caused the transaction and fraud caused the loss.

Loss causation, that the fraud caused the loss and not just the transaction, to be proven must be distinguished from broad market declines or other causes. While that conclusion facially makes sense, the allegation was that the broker dealer misrepresented the stock even to its retail registered representatives such that they misinformed the investors that the stock should be bought in ever increasing amounts, that the stock was a “great deal,” and that the stock should be purchased to the exclusion of all others. The investors claimed they were told the stock issuer had millions of dollars in contracts with other major companies and even Citigroup itself. The 7th Circuit conceded this might be “poor portfolio design” but questioned whether it was fraud.

Historically, sales practice violations by broker dealers, once proven, resulted in a recovery for the investor if the sales practice violation caused the loss by leading the investor into a purchase that should never have been made. The 7th Circuit abandoned this approach for the federal securities laws, and imposed further on the securities laws that the alleged fraud had to be actual cause of the diminution in value of the stock, rather than just the faulty purchase decision.

The 7th Circuit claimed that this theory was of long standing law but if that was the case, the federal securities laws would have been abandoned as a failed experiment long ago. Interestingly, the 7th Circuit did not summarize the fate of any state law claims, like negligence, common law fraud, violation of state securities laws or breach of contract (the customer contract with the broker dealer). Thus, the investor’s case might not be gone, however, the 7th Circuit recites that judgment was granted and thus affirmed.

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The United States Securities and Exchange Commission just listed its laundry list of money laundering statutes. The list is designed to allow corporate compliance officers, especially in the securities industry, to be able to quickly run the check list on transactions. Hat tip to Investment News, in an article by Aaron Siegel. The list contains twelve specific statutes, a catch all category of links, and a “contacts” category. The list is embedded with links to statutes and other source materials.

While this list is very helpful to lawyers and researchers, I’m not so sure it is useful to compliance personnel trying to make decisions on the fly. Siegel reported that the SEC claims the list was developed for their examiners, but I suspect it was developed to help their examiners fill in the blanks on their examination reports. But, be that as it may, it is still a useful list.

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Regulation D exempts certain securities investment vehicles from registration with the government and generally permits the existence of some types of non-public securities owned by a handful of strangers. Typically, to invest in an unregistered security, the investor must be qualified. One of the ways they must be qualified is by being an “accredited investor.” An “accredited investor” is an investor that has assets that can be invested and that are valued at $1 million or more net of home ownership or earns more than $200,000 per year.

The SEC is reportedly considering revising the definition of “accredited investor” to make it applicable to hedge funds and to define qualification for hedge funds to include a minimum net worth of $2.5 million.

While this makes some sense, it does not go far enough. The reason the SEC is considering this is because the “suitability” requirements, which impose limits on the risk to which an investor can be exposed by a registered representative, do not apply to hedge funds which accept investors directly rather through a broker dealer. In order to make the “accredited investor” definition look like a suitability requirement, it should make the net worth threshold exclude not only the family home, but it should also exclude IRAs, 401(k)s, and other retirement vehicles like SEPs and life insurance cash value. It should also be limited to persons with at least ten years of investing experience with equities, or commodities, or options.

Eventually, some hedge funds will evolve into main stream investment vehicles that will have some sort of short form registration and will be offered by broker dealers. The suitability rules and the drive toward true diversification that motivates the best registered representatives will provide adequate protection. Until that day comes, the customer that would otherwise be served by a retail registered representative or broker dealer should not be in hedge funds. An updated definition for accredited investors will fill part of the gap for the rest.

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