Investment Advisor Litigation When the Market Corrects

When the stock market finally corrects it will be the eighth major correction since I first started working on Wall Street back in the 1970s. It may happen next week or next year but it will certainly happen.  When the market does correct investors will certainly experience some losses.

Everyone understands that the stock market goes up and down. That does not mean that investors should expect to lose a significant amount of the money they made during the bull market when the correction does happen.

At every correction investors who lose more money than they anticipated bring claims for compensation against their stockbrokers and advisors.  For a stockbroker registered at FINRA most of the claims will be handled by FINRA in an arbitration proceeding. As soon as the claim is filed it shows up on the stockbroker’s Brokercheck report.

Many of the investment advisors who are registered with the SEC or with a state agency but not FINRA also have arbitration clauses in their customer agreements. They too are supposed to amend their disclosure filings to report customer claims, but few do.  I know of investment advisors who have had multiple customer claims but still show a clean record.

Investment advisors are always considered to be fiduciaries to their clients. As such they required to fulfill all of the duties of a fiduciary.  A fiduciary’s first duty is to protect the assets that are entrusted to them.

You cannot protect the assets in an investment portfolio unless you are prepared to sell them when the market turns down.  For advisors who are paid based upon the amount of money in the portfolio this creates a conflict of interest that no one wants to talk about.

Too much cash in the portfolio invites the customer to withdraw the cash and invest in something else, like real estate.  Good advisors will offer a large variety of investments so that they can always find one poised to increase in value or provide a steady income.

This will be the first market downturn where a significant amount of assets are being held by robo-investment advisors.  When the next correction comes, robo-investment advisors are going to be likely and easy targets for the plaintiff’s bar.  Robo-investment advisors are not programmed to sell positions when the market begins to turn down and are likely to stay invested while losses pile up.

Robo- investment advisors select their portfolios using algorithms that are fed with historical market data.  Everyone knows that past performance is no indicator of future results but the SEC allows this sham to continue. For a robo-investment advisor to have any value it would need to be able to assess what is happening in the real world economy and what is likely to happen as a result.

Robo-investment advisors claim to use asset allocation to select their portfolios and to protect their customers from losses. The simple truth is that most robo-advisors (and many human investment advisors) have no idea how asset allocation is done correctly.

The idea behind asset allocation is that you can create a portfolio of non-correlated assets that will reduce the risk if some macro-economic event rocks the markets.  Most robo-investment advisors give lip service to the idea of a diverse portfolio but few actually construct their portfolios correctly.

Many human and robo-investment advisors construct portfolios with asset classes such as “large cap stocks”, “mid-cap stocks” “small cap stocks” and “international stocks”.  As regards most macro-economic events such as a spike in the price of oil or an increase in interest rates, these asset classes are perfectly correlated with each other, not the opposite as they should be.

Asset allocation is designed to deal with the constant yin-yang between stocks and bonds triggered by interest rate fluctuations. For a long term portfolio, you would accumulate bonds at par when interest rates were high. As interest rates peak and began to come down, you would expect stocks to begin to appreciate, so you would sell bonds at a premium and begin buying good stocks in different, non-correlated industries.

Asset allocation works because its portfolio re-balancing system is based upon the premise that you will buy-low and sell-high. Robo-investment advisors re-balance their portfolio based upon a pre-determined formula that simply ignores what is likely to go up and what is likely to come down.  Many human advisors do not do the kind of research necessary to intelligently re-balance a portfolio either.

I worked on a lot of claims against stockbrokers and investment advisors after the market crashes in 2001 and 2008.  They always put up the same, weak defenses.

First, they argue that no one can predict the top of the market.  That is absolutely true and totally irrelevant. The great bulk of intelligent, prudent investors only invest in stocks that they think will appreciate in value. If your robo (or human) investment advisor told you to buy APPL or a mutual fund or ETF of “international stocks” it is fair that assume that they did so after some analysis that concluded the position would appreciate. Otherwise the advisor brings no value to the relationship.

If the advisor is actually doing that analysis and it includes more than just consulting a Ouija board, sooner or later that analysis will say “sell” or at least indicate that the share price will not appreciate much more.  The most common indicator is price/earnings ratio which economists tell us will usually fluctuate within an established range. When prices get out of the range on the high side, they will usually decline and revert to established norms.

Next, brokers and advisors defend these claims by arguing that clients should stay fully invested at all times because the market always comes back. That is another insipid defense.  It is akin to suggesting that you should keep your hand on a hot stove because it will eventually cool down.

As we approach the end of this long bull market every investor should be happy with the gains that they made in their portfolio. The Dow Jones Industrial Average has more than doubled since the end of 2008.  Even if your portfolio had a smaller gain, why would anyone want to give those gains back when the market declines?

Next, advisors offer lame excuses as to why they did not hedge the portfolio against a market downturn. There are a number of ways to accomplish this but very few advisers have a system to do so effectively.  I have asked many advisors why they do not hedge their portfolios or include stop loss orders to protect against a serious loss. They usually tell me that they were afraid to sell positions because the market would resume its climb and they would miss further gains.

That particular defense only works if the advisor has some research that suggests the market will go higher still. Many of the advisors that I cross-examined over the years had nothing more than their own gut feeling.

Where advisors tend to really screw up is when they get into the habit of adding speculative “alternative” investments to a portfolio to “juice” the returns. This may be acceptable for people who understand the risks and who are willing to accept the losses if things do not turn out as planned.  That does not describe a lot of people who are sold these investments thinking that they are hedging against losses in other investments.

Real estate investments are commonplace as an alternative and many advisors will add an exchange traded REIT to a client’s portfolios. These are very different than non-traded REITs which are usually private placements. The risk is much greater if the investment cannot be sold and at least some of the value retained.  Non-traded REITS have been the subject of thousands of claims against brokers and advisors in the last 10 years.

At the end of the day most of an advisor’s clients turn over the management of their portfolio because they want the portfolio to grow. That should not be that difficult for any good advisor but like anything else, you have to know what you are doing and you have to put in the hours to do it right.

Giving good professional investment advice takes skill and it takes effort, but it is also a people business. The number one complaint that I heard over and over, year after year, from people who contacted me asking about suing their broker or advisor was always the same, “He stopped returning my phone calls”.

When the market takes a sharp downturn, people want advice. That is another reason why robo-investment advisors are likely to see more litigation when the down-turn comes. They are never going to hold your hand.

 

Elder Financial Abuse-the Fiduciary Rule and Broker/Dealer compliance.

There are two general rules in the financial markets that you should never forget: 1) the higher the yield or growth potential for any investment the higher the risk of loss, and 2) investments that have a higher risk frequently pay a higher commission to the stockbrokers who sell them.

Seniors and retirees often want to draw as much as possible from their retirement accounts every month. Stock brokers are constantly tempted to give the customers what they want (higher yields) because it puts more money in their own pockets at the same time. The end result is that a lot of seniors are steered into making investments that are riskier than they wanted or could afford.

To address this temptation head on, the Securities and Exchange Commission (SEC) has proposed a new standard of conduct for all stockbrokers. The SEC’s proposed rule states:
“The standard of conduct for all brokers, dealers, and investment advisers, when providing personalized investment advice about securities to retail customers (and such other customers as the Commission may by rule provide), shall be to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice.”

Although Registered Investment Advisers have lived and prospered under this “fiduciary” standard for decades, the financial services industry has organized an effort to assure that this standard will not apply to most stock brokers. This rule squarely hits the industry’s bottom line.

The rule is very much the result of many years of seniors being steered into riskier investments to increase the industry’s profits. In May 2015 the staff of the SEC and FINRA published a joint report of their examination of brokerage firms selling investments to seniors. The staff asked firms to provide a list of the top revenue-generating securities purchased by their senior investors by dollar amount. http://www.sec.gov/ocie/reportspubs/sec-finra-national-senior-investor-initiative-report.pdf

Variable annuities were among the top revenue generating financial products sold to seniors at 68% of the firms examined. Non-traded REITs, alternative investments such as options, leveraged inverse ETFs and structured products made the list at between 10% and 20 % of the firms.

A variable annuity usually comes with a significantly higher than average commission to the salesperson. While variable annuities do offer tax deferrals and other benefits that might be attractive to some investors, no one disputes that variable annuities are high cost, high risk and high commission products. It is no secret that the high load and withdrawal charges that can go on for years make variable annuities less suitable for investors as they get older.

All stock brokerage firms are required to have procedures in place where managers officially supervise all employees. As part of their supervisory efforts, most firms employ a compliance department, usually populated by professionals tasked with the supervision of every account on the firms’ books and every order that the firm handles.

Most compliance departments compile daily exception reports of the previous days’ trades that were uncharacteristic or fit within pre-determined parameters as potential problems. It is much easier to fix problems with trades before the settlement date.

There should be a similar system that would identify the sale of a variable annuity to a 70 year old retiree as outside the norm of expected behavior. If the surrender charges extend out for 10 years, the customer’s access to his own money is restricted until the customer is 80 years old. Throughout, the investment portfolio will be exposed to market risk. Often the customer could substitute a mutual fund or funds for the same investment purpose at much less cost.

Where surrender charges extend out for ten years it often means that the sales commission on this transaction might be a high as 10%. That is why the SEC’s proposed rule focuses upon the “financial or other interest of the broker”.

The industry firms sell more and more variable annuities each year and make a lot of money doing so. I am certain that their shareholders expect nothing less. If you have been thinking about the “Fiduciary Rule” debate on a philosophical level, this is where the regulation meets the cash register.

The risk tolerance of each customer, for each transaction, is considered by the stock broker, the supervisor, and the compliance department. An investor’s risk tolerance can be easily ascertained with the question: how much of the money that you are investing are you prepared or willing to lose?

Many non-traded REITS began their lives as private placements issued under Regulation D. Once you buy them, selling them can be very difficult if not impossible. If the market turns against you, you have to ride the investment all the way down. In 2008-2009 many non-traded real estate investments lost significant value or went bankrupt. An investor in a non-traded REIT can often suffer a total loss.

Again, the SEC is keenly aware that these private placements often pay very high sales commissions. The SEC also knows that there are a multitude of comparable REITs that are liquid because they trade in the public markets and can be bought or sold for normal brokerage commissions and on any day the markets are open for trading.

Is it fair, then, to ask why a professional compliance department would not think it odd that a great many seniors seem willing to invest large amounts in clearly speculative investments when similar investments are readily available with much less risk and much less cost? Can the industry make a plausible argument that higher commissions do not drive these sales?

The industry is fighting for the right to set commissions at levels it deems fit without due consideration of whether the extra cost makes any sense from the investors’ point of view. Adopting this rule should lower commissions and customers costs overall and promote market efficiency. Diverting seniors to safer, less expensive products at the same time cannot be anything but positive.

Why your stockbroker is not a fiduciary

In the Dodd-Frank Act, Congress mandated that the SEC consider raising the bar for all stockbrokers and registered investment advisers (“RIAs”). The Commission responded with a recommendation that all stockbrokers and RIAs be held to a fiduciary’s standard of care.

The uniform standard proposed by the SEC, states:

The standard of conduct for all brokers, dealers, and investment advisers, when providing personalized investment advice about securities to retail customers (and such other customers as the Commission may by rule provide), shall be to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice.

RIAs have been held to this standard for a long time. In California and several other states stockbrokers are held to a fiduciary’s standard of care which imposes a duty on the broker to act in the highest good faith. The law in California is rooted in a case decided in 1968 and somehow the markets have continued to function.

Notwithstanding, many in the financial services industry strongly oppose any type of uniform standard that would hold a stockbroker to a fiduciary’s standard of care or require a stockbroker to exercise good faith as regards their public customers. Why?

If you are older like I am and practiced law in New York back in the day, you might remember when lawyers who were acting as trustees of their client’s money were likewise held to a fiduciary’s standard of care. At the time there was a “legal list” of investments that were appropriate for a fiduciary’s consideration. This list was very restrictive and strategies like using margin were prohibited.

The standard was modernized to the “prudent man rule” and later the “prudent investor rule” which were more ambiguous than the legal list and gave trustees and other fiduciaries a little wiggle-room. Prudence would still not find a fiduciary investor in the commodities markets or purchasing purely speculative investments.

A fiduciary would have a difficult time justifying the recommendation of speculative  investments in any event. Fiduciaries are expected to protect and to preserve the assets that are being entrusted to them.

Speculative investments frequently offer stockbrokers much higher commissions than investments that are less risky. Under a fiduciary standard, stockbrokers would certainly have difficulty arguing that they were putting their clients’ interests first when they were recommending a speculative investment that paid them an 8% or higher commission.

Perhaps that is the point that the SEC was trying to make when it said: “without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice.”  A stockbroker who recommends speculative investments to an average customer just to earn a little more commission would fit squarely within this rule.

A stockbroker necessarily implies to the customer that every investment they recommend is in the customers’ best interest. By refusing to adopt the standard, the industry is saying that it reserves the right to recommend investments that are not in the customers’ best interest just because the industry can make a little more money.

Whether the final rule will continue to allow stockbrokers to put their own interests before their customers’ interests remains to be seen. Perhaps the Commission will opt for full disclosure and require stockbrokers to disclose that one of the factors supporting any recommendation of a speculative investment is the fact that the investment pays higher commission.

Probably not.