What is Wrong with FINRA Arbitration? Nothing.

FINRA arbitration provides a simplified procedure for a customer to resolve any dispute that they may have with their stockbroker or stock brokerage firm. The rules of evidence are relaxed and arbitrators will often ask questions of the parties and witnesses to make certain that they understand what has occurred. That should benefit any skilled litigator representing a customer in this forum.

Notwithstanding, I constantly read articles about how FINRA arbitration is unfair. Lawyers who represent customers claim that the arbitrators favor the industry.  Some complain that arbitrators are not required to follow the law nor give reasons for their decisions. Others argue that they cannot conduct adequate discovery because depositions are not allowed.

Many stockbrokers also think that FINRA arbitration is unfair. More than one stockbroker has referred to the arbitration forum as a “kangaroo court”.

There are a handful of elite lawyers who regularly practice in this forum on both sides of the table. There are many more who are competent (if not inspired) and then there are those who complain because they frankly miss the point. The lawyers who complain the loudest about the arbitrators are the lawyers that cannot put the facts in their proper context.

Many lawyers who practice in this forum, on both sides, have no real understanding of the day to day functioning of a brokerage firm or the actual relationship between a broker and a customer. They often cloud the proceedings with irrelevant information and misguided assertions.

Arbitrators are fact finders, not judges. Lawyers should explain the dispute to arbitrators in the way arbitrators understand it, rather than complaining that the arbitrators do not understand the claim the way the lawyers want to present it.

I was trained in broker/dealer compliance. Arbitrators are frequently concerned with the same thing that concerns compliance officers; was this a “good trade”? Whether or not Rule 10b-5 was violated is usually irrelevant.  That is why you cannot approach FINRA arbitration in the same way that you would approach a case being filed in court.

When a lawyer drafts a complaint for court, the focus is on the legal causes of action. They make certain that the complaint is legally sufficient because failure to do so will get the complaint dismissed long before the hearing.  FINRA arbitrators rarely dismiss a claim except under limited circumstances, so customers are almost always assured of getting their claim heard.

When I draft a claim for FINRA arbitration I tell the panel what happened in a narrative form.  I focus on what the broker did wrong or why the investment product was defective.  And I tell the arbitrators why those facts caused the loss that the customer suffered.

Many customers want to file claims against their broker because they feel that their trust in the broker has been violated. Trust is hard to prove and often not relevant to the facts at hand.

The securities laws are grounded in the idea of “disclosure”, not trust.  Customers must be told everything they need to know. Like all financial institutions, the brokerage industry has systematized this disclosure into the fine print that is included in the customer agreements, margin agreements, confirmations and monthly statements. All of these disclosures have been approved by the appropriate regulators.

Products like variable annuities and private placements which are the subject of many of the arbitration claims usually require a customer to sign a form declaring that they have received everything they are entitled to receive. With private placements customers sign a form that states that they have read the disclosure documents, had an opportunity to ask questions and were told to review the transaction with their own attorney and tax advisor before they make the purchase.  Obviously, that makes it more difficult for customers to claim that they did not get the disclosures that they should have gotten.

Many claims invoke FINRA’s suitability rule which requires brokers to have a reasonable basis for any investment recommendation that they make.  It rarely comes into play where the customer is self directed using an account at a discount brokerage firm.

You also need to appreciate that a reasonable basis for recommending a stock is that the broker thought that the price would go up.  A recommendation can often be justified by good news or bad news about the company or the market. No broker has a crystal ball.

Brokers are required to only make recommendations in accordance with the customer’s “risk tolerance”.  At the hearing this is going to come down to a simple question that will be asked of both the broker and the customer: “how much money was the customer prepared to lose?”

Once the answer to that question is ascertained, defense counsel will invariably bring out the monthly account statements.  Arbitrators have little sympathy for customers who do not read the monthly statements or who claim not to understand them.

Everyone knows that the stock market goes up and down and sometimes crashes. Customers are often asked: “your account went up 20% from where you started, didn’t it occur to you that it might go down by that much or more?”

Not every customer who has a loss has a cognizable claim. The firm or the broker must do something wrong and the wrong must be the cause of the loss.  A suitability claim is essentially a negligence cause of action and legal defenses to negligence such as “comparative negligence” and “last clear chance” come into play even if they are not expressed as such.

Beginning in the late 1980s, more and more “product” cases began to surface. These were easier to prove because there was always a prospectus or similar disclosure document which either made all of the material disclosures or did not.  But finding facts that were not disclosed takes work.

In the mid-1990s I worked on about 2 dozen claims against a number of firms that had sold notes issued by a large Ponzi scheme. The operators of the scheme had been indicted by a state regulator. At that time court documents were not available on the internet.  I contacted the prosecutor and obtained an affidavit that had been sworn by a Deputy Attorney General that had been submitted to the Court as part of an asset freeze in the criminal case.  It laid out the whole scam in great detail.

I would attach the affidavit to my pre-hearing briefs. Most of the defense lawyers who handled multiple claims for their brokerage firm clients had never seen it before, meaning many of the other customers’ lawyers had not bothered to pick up the phone and contact the prosecutor.

I had a similar experience during the tech wreck/research analyst cases. My partner and I flew back to New York and spent two days in the windowless basement of a mid-town office tower reviewing documents that had been produced in one of the class actions.  We came away with enough to prove what we needed to prove in our arbitration claims but it took time and effort to do so.  I know that a lot of other lawyers representing customers had never bothered to make the effort.

Discovery is the key part of any FINRA arbitration and FINRA has established lists of documents that are presumed to be relevant to different types of claims. These are usually exchanged without incident or discussion although I have seen instances where defense lawyers claim that some of the requests are “vague and ambiguous” even though they have responded to these same requests many times before.

Supplementary discovery requests are permitted but not depositions or interrogatories.  It helps if the customers’ lawyer understands the paper flow and record retention requirements of the brokerage industry.

Every single order (buy or sell) that is entered by a broker on a customer’s behalf is approved by at least one supervisor at the firm and a record of that approval is kept.  Orders that fall outside of pre-established guidelines become the subject of exception reports and are further reviewed by the compliance department.  All marketing materials that a broker hands out and all outgoing correspondence are reviewed and approved as well.

I am frequently amazed how little of a paper trail the industry produces in many cases. The most important documents, such as the broker’s notes setting forth why he told the customer to buy XYZ at $100 per share never seem to find the light of day.

The most outrageous abuse of the arbitration discovery process, in my opinion, was committed by Morgan Stanley which claimed, falsely, to have lost millions of e-mails when its headquarters in the World Trade Center was destroyed on 9/11.  Morgan Stanley was fined and a fund was set up to repay customers whose arbitration claims were tainted when its duplicity was ultimately uncovered.

Product cases often become “battles of the experts”.  FINRA rules require a high level of pre-offering due diligence by the firm. The customer needs to prove that the firm acted below the industry’s standard of care which usually means setting out the facts that were not disclosed or demonstrating how little due diligence was actually done.

There were a great many claims that were the result of losses from real estate private placements after the real estate crash in 2008.  The more successful claims involved private placements or private REITS where the disclosure documents were deficient. But again, you have to prove what is missing. The best experts are people who have written disclosure documents themselves.

Customers’ lawyers have already begun to file claims due to losses on oil and gas offerings as the price of oil has tanked.  As these programs cut dividends or file for bankruptcy fraud and other problems are frequently revealed.

These claims should be easier for customers’ lawyers because a due diligence investigation of an oil and gas investment is more complicated and costly than an investigation of a real estate offering.  In many cases, the smaller FINRA firms that sell these offerings do not want to spend the money to perform a due diligence investigation properly.

One issue that frequently draws negative comments about FINRA arbitration is the subject of damages. Arbitrators will often apportion the loss between the parties. In times of a market decline, they will often consider the fact that if the broker had done everything correctly or purchased different investments the customer might still have lost money.

Have I ever had a bad arbitrator? Yes. I have been in front of arbitrators who fell asleep, were preoccupied with other matters or just did not understand what was going on.  It is rare, but it has also happened with judges.

The organized investors’ bar association has reformed the FINRA arbitration to allow panels to be constituted without any member who has worked for the industry. Personally, I always want someone on the panel who understands how a broker or brokerage firm is supposed to act.

The complaints against FINRA arbitration are part of a larger movement to move many kinds of consumer disputes away from arbitration.  That would send these disputes back to courthouses that are already swamped. In many parts of the country consumers can wait 5 years for their case to be heard and spend tens of thousands of dollars in deposition and other preparation costs.

Investment cases are difficult to win because investors are not ordinary people who get struck in  by a car in a crosswalk. They know that they can lose money every time that they invest.

Investors are usually given all of the disclosures that they are supposed to get. They certainly know what they are buying, how much they are spending  and how much their account is worth, every month. Does it surprise you that defense lawyers frequently ask: “if you were unhappy with the losses in your account, why didn’t you just tell your broker to sell everything and quit before the losses doubled?”

The fact that many of these cases are difficult to win is not the forum’s fault.

I cannot be the only person who regularly practiced before FINRA arbitrators who believes that the system works well enough to be left alone. Well meaning consumer groups should think twice before they argue that investor claims are better heard in court.  And lawyers representing investors should consider that the arbitrator bias and other problems they keep complaining about may actually not be as prevalent or as harmful as they seem to think.

Fiduciary Investing Made Easy

Every so often a client or colleague would seek my advice about what is really a very simple problem. They served on the board of their alma mater or a local charity. They had been tasked to help select an investment advisor for the endowment. They usually find themselves in this position because they know something about investing. Frequently it is because they handle their own portfolio through one of the discount brokerage firms.

But that is not the same as evaluating a professional investment advisor to handle other people’s money.  They want to find a good advisor for the fund and they do not want to make a mistake.

The same methodology that I am going to suggest would be appropriate for a business owner or investment committee seeking an advisor for a corporate pension plan.  The money in the plan belongs to the employees. They are counting on that money to fund their retirement.

The Department of Labor (DOL) has proposed new regulations that will shortly become effective and will hold all stockbrokers that handle pension or retirement accounts to a fiduciary’s standard of care. Registered Investment Advisors have been held to this standard for decades and if you are overseeing a pension plan or endowment you should hold yourself to the same standard as well.

The DOL regulation deals primarily with the costs or fees of the investments. It targets high commission investment products like private placements, hedge funds and variable annuities that are also high risk. I find it amazing how many large pension funds have allowed themselves to “diversify” into these alternative investments that they know very little about.

You should know that there are significant shortfalls in a great many large pension funds both public and private.  By shortfall, I mean that they do not have enough money to pay out the benefits that they have promised to their employees.

In many cases, this is a result of the managers trying to “do better” than the market to get higher returns for the fund.  Seeking higher returns means that they took higher risk and got burned.  Getting an underfunded pension fund back to par is very difficult without taking on even more risk.

Pension fund managers do get sued by plan participants for losing money. Corporate executives who oversee the advisors do as well. A good perspective for anyone who is sitting on a committee overseeing investments for a pension fund or an endowment is to adopt the same rule that doctors apply to their practice: first, do no harm.

You should also know that asset allocation for a pension plan or endowment may be a little different than you might think.  For a purely long term portfolio, funds are allocated between stocks, bonds and cash according to a pre-determined risk profile and re-balanced as market conditions shift.

If the pension plan is already paying out benefits or the endowment is being tapped to cover operating expenses or grants, then the fund must have enough income producing investments to cover the cash outflow. It is never appropriate to selloff portfolio securities to fund expenses. This is a mistake that a lot of individuals make in their own retirement accounts.

That leaves the selection of the equities that the fund will hold for the long term, stocks that will appreciate over time and allow the fund to grow. It is at this point that the investment committee is likely to have the most difficulty.

Many people believe that the cost of an investment advisor to help select the investments in the fund should be a determining factor. People seem to think that no-load mutual funds or ETFs are the way to go because an annual fee will diminish their returns.

At best you will get returns that are average, because you are investing in the good stocks in the sector or index along with the poorer stocks. You can and should hire a good advisor who does their own research to select a portfolio that will do better than the index.

There is an ongoing discussion regarding the merits of using a passive investment strategy (index funds or ETFs) versus using an active portfolio manager. In addition to higher costs, there are studies that suggest that the average investment advisor does no better than the indexes and many do worse. In my mind, it begs the question: why would you hire an average investment advisor in the first place?

So the real problem is to identify an investment advisor who is better than most or at least can reasonably be expected to get better results than an index.  If there are 30 airline stocks in an airline sector fund or ETF, then you would want an advisor who could research and rank those stocks and buy not all, but only the best.

A really good research shop is a rarity. All of the large brokerage firms and investment banks have research departments. Many of the analysts are excellent and insightful. But the research department is still often an adjunct to the firm’s investment banking operation and may be conflicted.

There are, of course, independent research reports that are provided by discount brokers who have no investment banking operations and others that are available by subscription that are used by many advisors. But none of these can be called anything but middle of the road and may be the reason that many active advisors get average results.

There is, in my opinion, a research based investment advisory firm that rises above the rest.  It is called Dimensional Fund Advisors (DFA).  You will not find their ads on most financial websites. They do not fill your e-mail account with spam or pop-ups. They do not write magazine articles aimed at mom and pop investors.

They actually do not even employ relationship managers (salespeople) in the traditional sense. You can only approach DFA to manage your funds through a limited group of pre-screened independent advisors.

I have known about DFA for decades. Several years ago I attended a presentation by one of their analysts and came away very impressed. They employ a bottoms-up, book value versus market value approach with the goal of picking the best stocks, one at a time.

This type of text book, academic approach to portfolio management is not that easy to find. The primary principals of the firm, Ken French and Eugene Fama are academics. Prof. Fama won the 2013 Nobel Prize for Economics.

Even if you are a DIY investor managing your own modest portfolio at a discount brokerage firm, I would encourage you to visit the DFA website, search out some articles and learn their approach to stock selection. Knowledge, after all, is powerful. I actually shudder when someone managing a few million dollars of their own money has never read a textbook on fundamental securities analysis.

If you have a larger account or find yourself in the position of overseeing a pension fund or endowment and would like more information or an introduction to DFA, I can refer you to one of the independent advisors who has a relationship with them. It is the same gentlemen who secured me a seat at their analyst’s presentation

Understand that I receive no compensation for this in any way.  If you follow my blog, you know that I routinely point out foolishness in the marketplace. I have written several articles on why people are foolish to manage their funds with robo-advisors.  This article, I hope, provides some balance.

It is the methodology employed by DFA that puts them above other advisors. It is the same methodology that you  should employ in your own account and seek out in an advisor for yourself or if you are asked to find an advisor for an endowment or company pension plan.

And telling your employees that you value their contribution to your company so much that you hired a Nobel Prize winner to manage their retirement funds, in my opinion it is not likely to get you sued.


SEC v. Ascenergy; Crowdfunding’s First Black Eye

The Securities and Exchange Commission (SEC) has brought its first fraud enforcement action that occurred on a Crowdfunding portal  http://Ascenergy LLC et al. (Release No. LR-23394; October 28, 2015).  The Commission alleges that a Texas oil company called Ascenergy raised $5 million from 90 investors on at least four Crowdfunding portals including crowdfunding.com, equitynet.com, fundable.com and angel.com.

Ascenergy claimed to be raising funds to drill oil wells on leases that it had evaluated and secured. The investors were defrauded because Ascenergy had not secured any leases. The person whom the company claimed had evaluated the leases had not done so, did not work for the company and had not agreed to allow his name or resume to be used by Ascenergy to raise money.

Ascenergy used false and misleading facts and omissions to create a false legitimacy which the portals and the public readily accepted. The Commission noted that Ascenergy’s website contained false claims of partnerships or associations with several legitimate companies whose logos appeared on Ascenergy’s website, also without permission.

Investors were told that investing in Ascenergy was “low risk” and that its shares were “liquid” when they were neither. The vast bulk of the money raised was spent on what the SEC calls ”personal expenses” of the person who thought up this scam and who might have gotten away with it.

Scams like this are common in the mainstream Regulation D private placement market. It is more likely that the due diligence process at a Financial Industry Regulatory Authority (FINRA) member firm would not have passed Ascenergy along to investors. No FINRA firm would likely have allowed Ascenergy to call its offering “low risk” or “liquid”.

The SEC’s complaint charges Ascenergy with fraud under the same sections of the federal securities laws that the SEC has been citing for decades. The SEC has made it clear that it expects Crowdfunding portals to actively seek to keep scams off their websites. The SEC has been just as clear that the anti-fraud provisions of the securities laws absolutely apply to Crowdfunding transactions.

The final Crowdfunding rules encourage and almost mandate portals to become members of FINRA. FINRA has established guidelines for due diligence investigations for private placement offerings. The FINRA due diligence standards seem reasonable to adequately keep scam artists away from public investors.

As scams go Ascenergy was not particularly novel or complex. FINRA firms have conducted thousands of due diligence investigations of oil drilling programs over the years. No due diligence investigation properly done by a FINRA member firm would have let Ascenergy claim to have secured leases without verification.

The portals generally do not conduct anything close to this type of due diligence investigation. The investigations can be costly and most portals elect not to spend the money. Very few of the Crowdfunding portals even attempt to conduct a substantive investigation sufficient to catch the “bad actors” let alone the “bad” deals. But do the portals assume the risk?

If you were one of the 90 investors who purchased Ascenergy on one of the four portals listed above, send the portal an e-mail and ask for your money back. Tell them that you have been defrauded because the portal failed to do its homework. Please copy me on the correspondence. I am curious to see how much denial the Crowdfunding industry is in.

Let me predict the future. The next SEC enforcement action will not mention the Crowdfunding portals in passing. The next SEC enforcement action (or the one after that) will find the portals being named as defendants and subjected to significant fines. The SEC has no real budget for Crowdfunding enforcement. In my opinion the SEC’s Enforcement Division is more likely than not to make an example out of an offending portal to send a clear message to the Crowdfunding industry that they must actively attempt to keep fraudulent offerings off their websites. That is, if the industry did not get the message the Enforcement Division delivered in its complaint against Ascenergy.

If any of the portals or their advisers disagrees I would like to hear from them as well. The literature surrounding Crowdfunding is rife with experts who have little or no experience actually preparing securities offerings or raising money from investors. I have seen many articles by “good” lawyers suggesting that a due diligence investigation is an unnecessary cost or that a superficial investigation is sufficient for a small Crowdfunded offering.

The problems that the SEC found with the Ascenergy offerings should not have occurred. Investors should not have had their $5 million stolen. The four portals that facilitated Ascenergy’s fraud owe at least an apology to the investors who got scammed.

Some people in the Crowdfunding industry have already suggested that Ascenergy is an isolated case. As I have written elsewhere, there are a great many portals that are currently offering securities for companies that are obviously not telling investors the whole story. Perhaps it is a little easier for me to spot an investment scam because I have seen so many, but that is exactly the expertise that the portals need and lack.

The Crowdfunding industry projects $40 billion in Crowdfunded offerings next year. The bulk of these offerings will be executed by buyers, sellers and portals that are mostly novices in an uncharted and unregulated market. If you wanted to commit securities fraud, what better opportunity could you find?

The Crowdfunding industry is justifiably jubilant about its prospects for success. Small companies have good reason to cheer this large infusion of new capital. But are the investors jubilant? Certainly not the 90 people who put up $5 million for the securities sold by Ascenergy.

I would advise crowdfunding.com, equitynet.com, fundable.com and angel.com to carefully consider their position should any defrauded customer correspond or a member of the financial press come knocking. A public pronouncement that due diligence is unnecessary or that a cursory investigation is sufficient will likely be used against you in a court of law.

The crowdfunding industry has very few investors who are loyal to one portal over another. It should be obvious to the industry that exposing investors to scams like this will not build loyalty, but will send investors back to their stockbrokers at mainstream brokerage firms.