FINRA Arbitration – How investors actually fare

Arbitration is arguably the most efficient way for public customers to resolve a dispute that they may have with their stockbroker. I have personally been a participant in a great many more securities industry arbitrations than most people.

But the arbitrations themselves have become suspect. Too many customers who have clearly been defrauded by their stockbrokers are walking away uncompensated and shaking their heads. A brief case study will illustrate the point.

I located only 35 awards in the FINRA Arbitration Awards database concerning securities issued by a company called DBSI. DBSI was a national real estate syndicator that filed for bankruptcy protection in 2008 and was shown to have been operating as a Ponzi scheme.

I chose DBSI claims for three reasons:

First, the Examiner working for the DBSI’s Bankruptcy Trustee filed a comprehensive report detailing how DBSI had operated as a Ponzi scheme from at least 2004 at which time DBSI was already insolvent. Like any classic Ponzi scheme, DBSI was using funds collected from new investors to pay obligations to prior investors.

Second, virtually every private placement offering that DBSI made after 2004 (approx. $800 million in total) contained an un-audited balance sheet that stated, falsely, that the company was actually solvent. This was important because with each offering the company was taking on financial obligations to the investors, mostly lease payments for the buildings that it was syndicating.

Third, brokerage industry standards require the firms that sell private placements to verify the information that they are handing out in the private placement memorandums s (PPMs). Verifying DBSI’s claim that it was solvent when it was not would not have been possible. Logic and experience suggest that the approximately 100 brokerage firms that sold DBSI securities failed to conduct a reasonable due diligence investigation if they conducted any investigation at all.

So, we have an independent report filed with the Bankruptcy Court that would seem to establish that investors were given false financial information about DBSI at the time the brokerage firms sold the DBSI securities to them. The principal of DBSI was also convicted of fraud, on basically the same facts, at his criminal trial.

We also have aggrieved investors who begin the FINRA arbitration process knowing that the investment that their stockbroker had sold to them was a Ponzi scheme. The public investors should have a reasonable expectation that a securities industry arbitration panel would find that selling interests in a Ponzi scheme to be beneath industry standards and be willing to award the investors adequate compensation.

So how did the complaining investors actually fare?

Of the 35 awards involving DBSI securities that I could locate in the FINRA Arbitration Awards database, the results were as follows:

In 8 of those claims the brokerage firm had either filed for bankruptcy protection or defaulted and failed to appear at the hearing. In two of these claims the brokerage firm was not a named party presumably because it had gone out of business. A substantial number of the brokerage firms that sold DBSI securities did exactly that. Had they not, I would think that there would have been a lot more claims.

The arbitrators made awards in several of these “defaulted” claims where the customers were able to prove up their claim and establish their damages. There is no indication that the defaulting firms actually paid anything to these customers. A brokerage firm that will not defend a claim will generally not pay the award.

In FINRA statistics these count as a win for investors because an award was made, even though the customers did not actually receive compensation for their losses. FINRA does not require its member firms who sell these private placements to have either adequate net capital or adequate insurance. FINRA does not take any steps to enforce an award against the principals of a firm who sell Ponzi schemes and then close up shop.

In 10 of the 15 claims where the brokerage firm was present and represented by counsel the arbitrators dismissed the claim or awarded the investors nothing. One has to wonder why these 10 panels of arbitrators could not be convinced that selling a Ponzi scheme to public customers was conduct for which the customers should be compensated.

In the 5 fully adjudicated claims where the arbitrators did make an award in the customers’ favor, in only one did the panel order the offending DBSI investment rescinded and the customers fully compensated. The rest of the awards were for much less than the amount that the firms’ customers had invested.

In one of the adjudicated claims the panel dismissed the claim for one DBSI investment and made a small award on a second. Both of these offerings contained fraudulent financial information about DBSI. What could these arbitrators have been thinking?

Twelve of the claims brought by customers seeking compensation for DBSI losses were settled for undisclosed amounts. Pre-hearing settlements are often based upon each party’s evaluation of what might be their worst result if the claim is given to the arbitrators to decide. The fact that only one panel deemed it appropriate to rescind the DBSI transactions and fully compensate the customers would certainly impact the brokerage firms’ idea of what might be the worst result that they might suffer if they did not settle.

When you boil this down to the fact that in only one claim in 35 did the customer get all or a substantial award from the FINRA arbitration panel when all were clearly defrauded, it does give one pause to consider than something may just not be right.

Perhaps it might help to look at the expungement phase of some of these hearings. Claims like these are routinely expunged from the record of the individual registered representatives when the claims settle.

After a settlement, the arbitrators conduct a live or telephonic hearing to determine if the claim should be wiped from the representative’s record. The claimants and their representatives do not usually appear at this hearing, nor should they need to appear. Left alone with the arbitrators some industry firms may be taking advantage.

In more than one claim the expungement order noted that the claim (for selling a Ponzi scheme to a public customer) was factually impossible. In others, the panel held that the offering materials (which contained fraudulent financial information) were within industry standards or that the due diligence (which, if done correctly could not have verified that DBSI was solvent as it claimed to be) was adequate and also within industry standards. I personally refuse to believe that industry standards have fallen that low.

These findings by the panels are often supported by “experts” whom the brokerage firms bring to the expungement hearings to educate the panels without cross-examination. If an arbitrator hears this recitation of “industry standards” from an expert or two provided by the industry over several cases, many apparently start to believe it.

It is certainly logical to assume that after many claims involving DBSI and several other large Ponzi schemes that were sold to public customers in the last market cycle (Medical Capital, Provident Royalties, etc.) the arbitrator pool around the country may have been tainted by the patently false “opinions” of these industry “experts”. Arbitrators get no training in securities law or industry standards from FINRA.

Securities industry arbitration has always been considered to be efficient because it costs less than state court litigation. The cost of the forum should be irrelevant if the customers cannot realistically expect to obtain a reasonable recovery of their losses in cases like this. I cannot fathom that a series of 35 juries sitting in civil courts around the country would come up this many defense victories. If I am right then clearly there must be some defect in the FINRA arbitration system.

As importantly, the lack of compensation awarded to these aggrieved investors in FINRA arbitration forums re-enforces a business model where a broker/dealer can be inadequately funded, carry no insurance, affirmatively flaunt the rules, conduct inadequate due diligence and sell millions of dollars of fraudulent investments to thousands of investors. Once exposed, the principals can simply close up shop and open up across the street under a new broker/ dealer and start over.

Either way, if FINRA intends to advocate its forum as fair and equitable to the public investors, it should take steps to see that it really is.

7 Reasons Why Robo-Investing Will Not Work. Millennials – Wake Up

Robo-investing is the next really big, really dumb thing. Millennials are expected to pour enormous amounts of money into these programs in the next few years. That would be an enormous mistake.

Robo-investment programs promise to help users to set up investment portfolios now and then to help manage those portfolios for the next 25 or 30 years. The portfolio with which you will end up, all those years down the road, is likely to be a disappointment.

I looked at a number of the websites and advertisements for these programs as I was writing this article. One proposes that a”moderate risk” portfolio would have 90% held in stocks. Another has a member of their investment team who takes a “holistic” approach to financial planning. That may be fine for some people but is not a serious approach to managing your money as far as I am concerned.

These computer programs do not have what it takes to intelligently construct a portfolio for you now or to manage it over a period of many years. Years from now, you will wish that you had a portfolio put together and monitored by a well trained and intelligent flesh and blood investment adviser. By then it will be too late.

Robo-investment advisers tout the fact that they cost less than a human investment adviser would cost. It does not really matter. Robo-investment advisers are inexpensive because they provide investors with little or no value.

If you have any doubt that these robo-investment adviser programs are less than worthless, here are seven obvious reasons why the actual portfolio that you will get from a robo-investment adviser program is likely to perform poorly.

Number One: It is not about your age.
One of the few personal questions that a robo-investment adviser program will ask is your age. If you are thirty the program will assume that you can afford to take on more risk than a person who is sixty. If it is suitable for you to take on more risk then your recommended portfolio will get more stock funds or ETFs and fewer bond funds and bond ETFs.

Investing based upon your age assumes that your age and the markets are somehow related. What you should or should not buy today is dependent upon the market, not upon your age. If you start down this path, what you will have bought or sold over the years that you stay with the program will have had nothing to do with what might have been a good investment at any time.

Number Two: Today might not be a good day to invest in either stocks or bonds.
Let us say that the program suggests that you create a portfolio that is 35% bond funds or bond ETFs and 60% stock funds or stock ETFs with 5% held in cash. In truth, it does not seem that most of these programs ever hold a lot of your funds in cash which always increases the portfolio risk.

If you begin investing this year when the stock market averages are making new highs it is reasonable to expect that next year or the year after the market might correct. It is very possible that five years down the road 60% of your portfolio will be worth less than it is today.

After seven years of forced low interest rates is this a good time to put 35% of your money into bond funds or ETFs? Savvy investors know that bond funds do not do well when interest rates rise. The computer will not adjust for the hike in interest rates that everyone knows is coming until after it happens and the portfolio has taken the loss.

Number Three: It is about the right math, the right data and more.
Robo-investment advisers claim to have sophisticated algorithms that will crunch the numbers and produce good results. The algorithms may be good but these programs look at the wrong numbers. A robo-investment adviser never gets past a limited set of gross market data. A robo-investment adviser never actually looks at any company’s balance sheet. They are an example of the GIGO principle of statistical analysis; garbage in, garbage out.

It is not only about the numbers. Before I would invest in any company I would want to know about products that the company might have in the pipeline, what its competitors were up to and what the CEO is thinking about. I am not alone. A robo-investment adviser is never interested in these things that most other investors would want to know.

Number Four: Investing cannot be done in a vacuum.
The computer program does not get a live news feed and would not know if Germany had invaded Poland so events leading up to any crisis that might affect the markets and the portfolio would necessarily be ignored. The program does not concern itself with current commodity prices, currency rates or international politics. Intelligent investors do.

To my mind, using a robo-investment adviser to construct and manage your long-term portfolio is the same as making all of your investment decisions from inside a small closet with the lights off and the door closed.

Number Five: The markets will not be static for the next 25 years.
The noted theorists upon whose works Modern Portfolio Theory and asset allocation are based were examining data from the markets prior to 1990. The financial markets have evolved significantly in the last 25 years. It is not just the speed or the technology. The markets are now global, there are a lot more participants and there is a lot more money in play. How the markets will continue to evolve and operate in the next 25 years is anyone’s guess and is certainly not built into any robo-investment program.

Number Six: The data that the program uses to select portfolios is based upon the past performance of the markets and past performance only. I should not have to tell you that past performance is an unreliable indicator of future results. If you invest with any one of these programs future results are exactly what you are trying to achieve. Why use data that is unlikely to get you there?

Number Seven: Human beings are actually necessary.
The sales pitch for these robo-investment advisers suggests that can do better than any human financial adviser. One company even touts that its program alleviates the risk of human error.

Using a robo-investment adviser will inevitably lead to portfolio losses every time the stock market goes down or interest rates go up. It will never tell you to avoid downturns or to get out of the markets all together before a crash. Likewise, the program never looks for new companies that might do very well or for any other investment opportunities that might make you money.

Severe market downturns can be scary. Investors are prone to panic. When your account value is dropping you are going to want someone to call. The robo-investment adviser will offer neither solace nor advice. That will only come from a knowledgeable human being. For that you have to pay a little more.