Terra Extraneus

There is an old saw that compares lawsuits to two men armed with knives circling each other in a dark room, not knowing whether they can ever put the knives down. During the raiding wars (a/k/a recruitment wars) of the last twenty-five years, the major wirehouses, broker dealers, and investment banks tried to defend their market share by making it difficult or impossible for stock brokers (a/k/a registered representatives, financial advisors, financial consultants)(“FCs”) to change jobs, even though they are mere at will employees.

One of the most aggressive and effective firms at defending its turf when stock brokers tried to change jobs and take their books of business with them was Merrill Lynch. Other firms were more vicious about it, and turned to forfeiture programs designed to put thousands if not millions of dollars of earned compensation at risk just for changing jobs, so Merrill Lynch was by far not the worst with which to deal.

Finally, however, the Courts began to wise up to the fact that, no matter what high sounding moral or legal issues might be used to justify the raiding wars and the TROs and emergency hearings they spawned, what was really at stake was the book of business, market share and business income. That led Merrill Lynch to develop the Protocol for Recruiting Brokers. About sixty broker dealers have signed up and Bank of America, Merrill’s new owner, just joined in the last couple of weeks.

However, during the recruitment drives of 2008, we are seeing the same contracts containing the same clauses that were used to obtain TROs and put the FCs on the beach since time immemorial. Also, no house will agree to insert any language deferring to the Protocol for Recruiting Brokers.

The houses all say the same thing about their refusal to incorporate the Protocol for Recruiting Brokers. Because any house can resign from the Protocols at any time, no house wants to make its employees third party beneficiaries of an agreement others might not keep. The men in the dark room carrying knives are still circling.

In these turbulent times when recruitment and job flight are at all time highs for FCs, it will be interesting to see if the houses panic over market share and withdraw from the Protocols. It will be interesting to see if courts have the sanity to impose the Protocols as an industry standard with or without signatories. A few courts have done so. See, Merrill Lynch v Brennan (D. Ohio 2007) (hat tip to the Firth Law Firm in Roanoke); Citigroup Global Markets, Inc. v Griffin, slip op. (District Court of Suffolk, No. 08-0022, 2008)(hat tip Social Law Library Research Portal at socialaw.com).

Courts should be reminded that historically courts have historically found these cases interesting for awhile and then later rued the day they let them flourish.

Petitioner’s [Smith Barney] protestations to the contrary notwithstanding, the Court does not foresee any cataclysmic repercussions for Smith Barney that cannot adequately be addressed by monetary damages which are easily calculable from the requisite documentation.

Smith Barney, Inc. v. Anthony Cappiello, Supreme Court, County of New York, No. 603445/98, July 20, 1998, Slip Op. at 3.

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Selling off, even in market “crash,” later called more accurately a “correction,” is usually driven by switching from the investment strategy based on company fundamentals to the strategy based on market timing. The market timing approach always fails because it is based on prophecy, only without God’s help. It fails because it is based on emotion, fueled by media language, and not business principles. It fails because it takes the investor out of the market just when opportunity, even in an inflated market, abounds.

A true market “crash” involved auction rated securities, which most people did not own. The regulators, for a change, made the issuers step up and buy the failed product back. This “recall” of a bad product made sense. Thus, that “crash” was defanged and the whole thing has all but fallen off the stage. If the regulators had not acted, the wirehouses would have turned it into a debacle because they were treating it as a sales practices violation by their own brokers. I compliment the regulators even though I was deprived of many years of gainful litigation employment.

This market down turn has the same lesson for investors all the others have had. Do not over concentrate. Diversify. Balance stocks (sometimes called equities) against other types of investments in a portfolio (bonds, CDs, mutual funds that are not themselves concentrated only in stocks) or against non-market investments like real estate. Read at least the first couple of pages of the prospectus to make sure the product, be it a mutual fund or whatever, does not over concentrate your portfolio. Do not rely only on your financial advisor to read it for you. Your financial advisor might need the commission that month, or might have been misled by the broker-dealer employing him or her. Most will do their best. When in doubt, get a second opinion from your Certified Public Accountant (except during tax season, when their attention is too divided). You should be in doubt enough to consult your CPA every two or three years even if you have a static portfolio, whether you think you need to be or not. Let your CPA scare you a little bit, even if you do not change anything. If they scare you a lot, rethink your strategy. Many persons who thought they might retire this year or next will regret not doing so.

Those of us that never gave up the concept of whole and universal life insurance still have cash value sitting there. While it might be at risk in a general depression, in every market “correction” I have lived through it has been “untouched.” It is just another diversification and another form of professional money manager, even if it is not a dramatic gainer. There may be better products to use, but I got in at a time in my life when I understood that product and did not understand the stock market, and it has always served me well.

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The demise of Bear Stearns and the bankruptcy of Lehman Brothers, followed by the purchase of Merrill Lynch by Bank of America, heralds the final end of the Wall Street business model.

B of A’s CEO claims that for seven years he predicted the commercial banks would end up owning the investment banks. Merrill’s CEO claims that this would be great for Merrill’s 16,000 registered representatives because they will have access to B of A’s customer base.

However, the bank owned model of broker dealers and the Wall Street model have been radically different. The banks have never been as tolerant of risk nor as tolerant of salesmanship. As a result, the banks have had a narrower range of products.

Merrill Lynch training and compliance has always been enviable in the industry. But, neither will be as necessary in the new world where banks dampen the sharp edges more than regulators. Banks like to charge fees and so many of the free services with which Merrill Lynch built its book of business will no longer be free. Banks like the wealthy and have very little to offer the non-wealthy (currently defined as someone with less than $500,000 of investable assets). Retail broker dealers liked everyone. It is interesting to see which business model failed.

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Investment News writer Darla Mercado reported that fixed and variable annuity sales by banks fells 4% in April and that for the third consecutive month, fixed annuities out sold variable. She quoted Jackson National Life Distributors, LLC as blaming the decline and the change in the mix of sales on “market volatility.”

It certainly could not be because consumers have figured out that for every nine well meaning and competent annuity sellers, there is one idiot, or fiend, on the loose using variable annuities to the detriment of their customers and attracted by commissions that are too high and consumers that are too gullible.

This is sad because variable annuities should be a good product. Why is it a poor product for the average consumer, especially consumers over 50?

Once the sale is made, banks, insurers and the financial services industry think they can turn their back on them. A variable annuity is like a car, it requires maintenance. The underlying funds and fund choices get out dated, hammered by the market or suffer from bad management, just like anything else. But, once sold, the only protection the consumer has from huge losses of principal is the selling agent. If the selling agent is an idiot, lacks worth ethic, or is perpetually on to the next big sale, the consumer is all alone with a product they do not have the tools to manage. Even some selling agents lack the tools to manage large numbers of these accounts and have to look at them manually in a disciplined manner.

I thought it was funny that Jackson National spoke out on the situation. I have a Jackson National product and it has lost 20% of principal and all earnings to date in the last quarter. This loss is purely market driven because I have one of the good agents and I litigate in this area for a living so I know something about it.

The other reason variable annuity products can be dangerous to older people is because the financial services industry uses terms that the consumer does not realize have meaning that will lead to unintended consequences. Everyone wants to be “moderate,” right? No one wants to be “speculating” or too “conservative” when it comes to financial risk. But, if the customer tells the securities industry that they are, indeed, a “moderate” investor, the customer is in reality telling the industry the customer is comfortable risking some principal loss, maybe as much as half.

Also, the term “growth” sounds like a good thing, right? Like “moderate,” to obtain growth means the acceptance of risk of principal. Most of the portfolios of elder customers I have reviewed, that is, persons well above retirement age, contained too much investment in “growth.” Most “growth” investments take at least five years to produce that “growth.” Most “growth” investments will fall at the same rate they rise. Very few “growth” investments are based on the stock issued by large corporate entities, but rather by the smaller and more vulnerable companies. But, too many customers move most of their principal into these products.
Fixed annuities on the other hand, too boring in good times, become more popular when the economics become uncertain.

It is amazing to me that organizations like AARP, the SEC, or the Congress, do not seem to recognize these defects. If the SEC would simply ban surrender charges or severely limit their use, variable annuities would not be the product of choice. If the SEC required an annual positions review in the variable account by the selling broker dealer, that might reduce the risk because supervisors would be forced to fill in the gaps left by the weaker members of their sales forces.

Market volatility should not be the only policeman on the street.

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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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Most people that engaged a financial advisor employed by a FINRA (formerly NASD) broker-dealer and all registered representatives signed something containing a mandatory arbitration clause. FINRA announced that for 2007, new arbitration case filings dropped to their lowest level since 1992. That is a staggering concession.

While some political forces have been trying literally forever to abolish or curtail arbitration, arbitration itself may be doing what political power could not do.

I have been handling securities industry arbitrations since 1988 and I have represented broker-dealers, registered representatives, and customers, although few of the latter, and I thought 2007 was a busy year. It seems, however, it was less busy than I realized.

The three years of lesser activity at FINRA Dispute Resolution, 1992, 1998 and 2006, averaged 4,644 case filings annually. 2007 was 70% of that average; 30% below the average of the lowest filing years prior to 2007.

It will be interesting to see if the industry credits one or more allegations of: good returns of 2007, good compliance initiatives, or something else. Could it be that the legal community has figured it out and has revised upward the criteria for case selection to offset the fact that it is a high risk forum?

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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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I saw an article in Investment News a day or so ago on this topic but after reading the article, could not tell what new event had led to the story. But, it led me to consider that even with a Democratic Congress in its infancy, there have already been bills submitted which would essentially abolish mandatory arbitration. So, the debate over whether FINRA should abolish the practice of mandating one industry arbitrator on each panel of arbitrators is again cutting edge. (FINRA, the Financial Industry Regulatory Authority, is the organization that resulted from the merger of the National Association of Securities Dealers, Inc. and the New York Stock Exchange, Inc.’s regulatory arm.)

The article by Dan Jamieson of Investment News contained the claim that industry arbitrators were the “good guys” because they were harder on industry “ne’er do wells” than public arbitrators.

Sometimes that is true and sometimes it is not.

FINRA provides to litigants a database that contains all of the decisions of every arbitrator proposed for an arbitration. Counsel can study the past decisions of an arbitrator and, if there are enough of them, can also develop a model of the arbitrators’ decision making proclivities that is sometimes predictive. For example, if an arbitrator has never awarded any money, or never an amount seemingly reflective of the claims, after sitting on several panels, it should be pretty clear that they are not likely to do it. Counsel for the aggrieved customer or aggrieved employee should not count on a break through with that arbitrator.

Many lawyers select arbitrators based solely on their respect for the arbitrator. While that is a good criteria, it should not be the only one. The mathematics of past decisions should be equal to or greater than subjective impressions. Half a dozen decisions is usually enough to gauge a prospective arbitrator, but a dozen is much better. Simple math tricks can also help: weighting types of cases, weighting the quality of counsel that have appeared in those past cases, weighting the awards, and dropping highs and lows. The passage of time should be considered; decisions more than a decade old may not truly reflect that an arbitrator has matured or ripened.

Arbitrators that have developed a decisional history that omits monetary awards are more often than not former branch managers. It is not hard to decipher the cause. Branch managers are historically front line cannon fodder for the wirehouses and appear at arbitrations as the company representative. They would not be sitting there, sometimes with their own career or future prospects on the line, if not for a customer or that disgruntled employee. At the very least, if there is an award by the panel, it usually comes off the bottom line of their office, and more directly, out of their bonus. It leaves an impression that is usually indelible. Even after many years of retirement, most former branch managers cannot strike that feeling of déjà vu. While most former or retired branch managers that are experienced arbitrators will deny that their bitter moments in arbitrations of long ago do not impact them in the here and now, their published voting pattern usually reveals something else.

Some of the most respected arbitrators are often the first struck from a prospective panel by students of their decisional histories. What would improve the standing of industry arbitrators is more stringent disclosures, including things such as the number of times the industry arbitrator has testified, the number of times they have acted as a company designee in litigation and arbitration, and clearer disclosures about whether they have ever suffered a professional or monetary set back because of an arbitrated claim. The current system of disclosures needs a tune up and bolt tightening.

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