Saturday, September 6, 2014

New FINRA Rule Limits usage of Expungement Requests in Arbitration


The SEC has approved FINRA Rule 2081 that would disallow brokers from conditioning settlement of a customer dispute on a customer’s consent to the broker’s request for expungment from the Central Registration Depository (“CRD”). The CRD is the licensing and registration system used by all registered securities professionals. The system enables public access to information regarding the administrative and disciplinary history of registered personnel, including customer complaints, arbitration claims, court filings, criminal matters and any related judgments or awards. Because of the open nature of information available to its investors, registered professionals would like sensitive matters, such as customer complaints, expunged from the record. 

The purpose of Rule 2081 is to make sure that full and reliable customer dispute data remains available to the public, brokerage firms, and regulators to prevent concealment by prohibiting the use of expungement as a bargaining chip to settle disputes with a customer. Furthermore, it allows regulators to make informed licensing decisions about brokers and dealers and improve FINRA’s transparency on broker-dealer complaint histories. This prohibition applies to both written and oral agreements and to agreements entered into during the course of settlement negotiations, as well as to any agreements entered into separate from such negotiations. The rule also precludes such agreements even if the customer offers not to oppose expungement as part of negotiating a settlement agreement and applies to any settlements involving customer disputes, not only to those related to arbitration claims.

On one hand, Rule 2018 will make it more difficult for brokers to sanitize their CRD report from a past claim, ensuring that future investors can more accurately assess the quality and integrity of a registered securities professional, ensuring protection from potential fraud and abuse.  On the other hand, settlements are a significant part of resolving FINRA claims in a timely manner.  If more FINRA claims reached arbitration, then the average FINRA claim would take substantially longer to adjudicate.  Ultimately, Rule 2081 could dissuade broker-dealers from settlement prior to arbitration because they may want to take their chances in arbitration, making an already potentially slow moving process, slower.

When investigating historical use of expungement in arbitration, pursuant to SEC Release No. 34-72649, the SEC found “despite the very narrow permissible grounds and procedural protections designed to assure expungement is an extraordinary remedy…, arbitrators appear to grant expungement relief in a very high percentage of settled cases.” In order to even seek expungement, FINRA Rule 2080 requires a showing that (1) the claim, allegation or information is factually impossible or clearly erroneous; (2) the registered person was not involved in the alleged investment-related sales practice violation, forgery, theft, misappropriation or conversion of funds; or (3) the claim, allegation or information is false. 

In approving Rule 2081, however, the SEC cautioned FINRA that the new rule should not be the last word on the subject of expungement and that FINRA should continue to consider making improvements to the expungement process. In this regard, even though “the proposed rule change is a constructive step to help assure that the expungement of customer dispute information is an extraordinary remedy that is permitted only in the appropriate narrow circumstances contemplated by FINRA rules,” the SEC nonetheless remains concerned about “the high number of cases where arbitrators grant brokers’ expungement requests.” SEC Release No. 34-72649


Official rule language:


2081. Prohibited Conditions Relating to Expungement of Customer Dispute Information.

"No member or associated person shall condition or seek to condition settlement of a dispute with a customer on, or to otherwise compensate the customer for, the customer’s agreement to consent to, or not to oppose, the member’s or associated person’s request to expunge such customer dispute information from the CRD system. See Regulatory Notice 14-31."

Cosgrove Law Group, LLC has experience with financial industry disputes including representing investors in recouping their losses and registered representatives seeking expungement. We also provide training, information, and compliance for registered professionals through the Investment Adviser Rep Syndicate.

Authored by Mercedes Hansen

Tuesday, August 12, 2014

Does your Investment Adviser Firm Have a Social Media Policy?

Social media such as Facebook, Twitter, LinkedIn, or blogs have become popular mechanisms for companies to communicate with the public. Social media allows companies to communicate with clients and prospective clients, market their services, educate the public about their products, and recruit employees. Social media converts a static medium, such as a website, where viewers passively receive content, into a medium where users actively create content. However, this type of interaction poses certain risks for investment advisers and this topic has been a hot button for securities regulators. 

The SEC previously issued a National Examination Risk Alert on investment adviser use of social media. As a registered investment adviser, use of social media by a firm and/or related persons of a firm must comply with applicable provisions of the federal securities laws, including the laws and regulations under the Investment Advisers Act of 1940 (“Advisers Act”). The Risk Alert noted that the various laws and regulations most affected by social media are anti-fraud provision, including advertising, compliance provisions, and recordkeeping provisions. Advisers Act Rule 206(4)-7 requires firms to create and implement social media policies, and periodically review the policy’s effectiveness. 

Anti-fraud provisions with respect to advertising are probably most affected by the use of social media. All social media use and communications must comply with Rule 206(4)-1. While advertising policies should already be included in a firm’s compliance manual, such policies may not be sufficient enough to address some of the concerns with advertising in the context of social media. Establishing a specific policy to address social media may be prudent.

The area of advertising that has caused the most confusion is the prohibition on the use of testimonials. The SEC has previously defined testimonial to include a statement of a client’s experience with, or endorsement of, any investment adviser. Firms and IARs must ensure that third-party comments on their social media sites do not constitute a testimonial. Furthermore, the SEC vaguely discussed whether the popular “like” function on many social media sites would be deemed a testimonial:

[T]he staff believes that, depending on the facts and circumstances, the use of “social plug-ins” such as the “like” button could be a testimonial under the Advisers Act. Third-party use of the “like” feature on an investment adviser’s social media site could be deemed to be a testimonial if it is an explicit or implicit statement of a client's or clients' experience with an investment adviser or IAR. If, for example, the public is invited to “like” an IAR’s biography posted on a social media site, that election could be viewed as a type of testimonial prohibited by rule 206(4)-1(a)(1).

The types of policies that firms must create concerning advertising and testimonials depend greatly on the function of a specific website. For instance, approving the firm or IARs use of certain websites may turn on whether that website allows for review and approval of third-party comments before such comments are posted on the site or whether the “like” function can be disabled. A firm’s monitoring capabilities and the latitude it wants to provide employees with respect to personal use of social media cannot be ignored either.

The SEC has outlined various factors that should be considered by an investment adviser when evaluating the effective of their compliance program. These factors are:
  • Usage and content guidelines and restrictions on IAR use of social media whether on behalf of the firm or for personal use
  • Mechanisms for approval of social media use and content;
  • Monitoring of social media use by the firm and IARs and the frequency of monitoring;
  • Consideration of the function or risk exposure of specific social media sites;
  • Establishing training and requiring IAR certification;
  • Whether access to social media poses information security risks; and
  • Firm resources that can be dedicated to implementation of social media policies.
There are various considerations firms must take into account when establishing social media policies or evaluating the effectiveness of its existing policies. If your firm needs assistance, the Cosgrove Law Group, LLC can assist with creation or review of such policies.

Friday, August 1, 2014

Who has the Right to Enforce Your Promissory Note?

A customary practice in the securities industry is for financial advisors to receive a transition bonus above and beyond an advisor’s standard commission compensation upon joining to a new firm. The bonus amount is usually determined using a certain percentage or multiplier of the advisor’s trailing 12-month production. These are usually referred to as “promissory notes” or Employee Forgivable Loans (“EFL”). Promissory notes are often used to solicit new employees/contractors from another brokerage firm. However, this “incentive” is usually cloaked with many restrictions. Typically these loans are forgiven by the firm on a monthly or annual basis but the advisor has to commit to the firm for a specified number of years or be required to pay the balance back to the firm should the advisor leave before the end of the term. 

Brokerage firms can enforce promissory notes through FINRA arbitration. Promissory note cases are one of the most common types of arbitration and the brokerage firms experience a high success rate with these cases. These proceedings are governed, in part, by FINRA Rule 13806 if the only claim brought by the Member is breach of the promissory note. This rule allows the appointment of one public arbitrator unless the broker rep. files a counterclaim requesting monetary damages in an amount greater than $100,000.  If the “associated person” does not file an answer, simplified discovery procedures apply and the single arbitrator would render an Award based on the pleadings and other materials submitted by the parties. However, normal discovery procedures would apply if the broker rep. does file an answer. Thus, if a broker wants to make use of common defenses to promissory note cases and obtain full discovery on these issues, the broker should ensure that he or she timely files an Answer.    
  
A recent trend with promissory notes is that the advisor’s employer does not actually own the Note. Sometimes this entity holding the note upon default is a non-FINRA member company, such as a subsidiary of the broker-dealer or holding company set up specifically to hold promissory notes. Many believe the practice of dumping promissory notes into a subsidiary is to circumvent the SEC requirement that brokerage firms hold a significant amount of capital (one dollar for each dollar lent) to protect against loan losses.  By segregating promissory notes into a separate entity, firms likely can retain much less to meet its capital requirements. 

Because a non-FINRA member firm may ultimately attempt to enforce the promissory note, questions arise as to how an entity can use FINRA arbitration to pursue claims against an agent.  The Note likely contains a FINRA arbitration clause but this may create questions of the enforceability of the arbitration clause. Furthermore, non-FINRA member entities cannot take advantage of FINRA’s expedited proceedings for promissory notes under Rule 13806 as this rule only applies to “a member's claim that an associated person failed to pay money owed on a promissory note.”

However, in order to make use of the simplified proceedings under Rule 13806, some member-firms have started a practice of sending a demand letter to the broker requesting full payment be made to the broker-dealer, rather that the entity that actually owns the note.  Broker-dealers have also attempted to simply add the Note-holder as a party to the 13806 proceedings. Reps should immediately question the broker-dealer’s standing to pursue collection or arbitration, the use of Rule 13806 to govern the arbitration, and potentially consider raising a challenge to a non-FINRA member firm attempting to enforce its right through FINRA arbitration. 


If you have recently received a demand letter seeking collection of a promissory note or are party to an arbitration, you may wish contact the attorneys at Cosgrove Law Group, LLC for legal representation.

Tuesday, July 29, 2014

Calculating Breach of Fiduciary Duty Damages

According to a variety of authorities including the SEC, the much-debated fiduciary duty for registered investment advisers and their representatives includes a subset of responsibilities[1].  Common sense would, or should tell you that the appropriate damage calculation for a breach of fiduciary duty will be directly dependent upon and vary according to the particular unfulfilled responsibility.  For example, a breach of the fiduciary duty regarding conflicts of interest or honesty, as opposed to mere suitability, will call for out-of-pocket damage compensation if these breaches occurred before any market-losses at issue.  Even in a suitability only arbitration, however, expert witnesses may debate the applicability of out-of-pocket loss calculations as opposed to model portfolio based market-adjusted damage calculations.

It is common in breach of fiduciary duty cases involving trustees to award damages in the amount necessary to make the beneficiary whole. Restatement of Trusts, Second, § 2205, (1957), provides that proof of harm from a breach of fiduciary duty entitles an injured party to whom the duty was owed to damages that: (a) place the injured party in the same position it would have been in but for the fiduciary breach;(b) place the non-breaching party in the position the party was in before the breach; and (c) equal any profit the breaching fiduciary made as a result of committing the breach. See also Restatement (Second) of Torts § 874 (1979) (“One standing in a fiduciary relation with another is subject to liability to the other for harm resulting from a breach of duty imposed by the relation.”).
Delaware law is consistent with this principle. In Hogg v. Walker, 622 A.2d 648, 653 (Del. 1993), the court noted that “where it is necessary to make the successful plaintiff whole” for a breach of fiduciary duty, courts have been willing to allow the plaintiff to recover a portion of trust property or its proceeds along with a money judgment for the remainder. The court in Hogg stated that “[i]t is an established principle of law in Delaware that a surcharge is properly imposed to compensate the trust beneficiaries for monetary losses due to a trustee’s lack of care in the performance of his or her fiduciary duties.” Id. at 654.[2]; see also Weinberger v. UOP, Inc., 457 A.2d 701, 714 (Del. 1983) (stating that in measuring damages for breach of fiduciary duty the court has complete power “to fashion any form of equitable and monetary relief as may be appropriate, including rescissory damages.”); Harman v. Masoneilan Intern., Inc., 442 A.2d 487, 500 (Del. 1982) (finding that “the relief available in equity for tortious conduct by one standing in a fiduciary relation with another is necessarily broad and flexible.”) (citing See Restatement (Second) of Torts, § 874 (1979)).

In O'Malley v. Boris, 742 A.2d 845, 849 (Del. 1999), the court stated that the relationship between a customer and stock broker is that of principal and agent. The court stated a broker must act in the customer’s best interests and must refrain from self-dealing, and that these obligations are at times described “as fiduciary duties of good faith, fair dealing, and loyalty.” (emphasis added) Id. The court further found that fiduciary duties of investment advisors “are comparable to the fiduciary duties of corporate directors, and are limited only by the scope of the agency.” Id.   Bear, Stearns & Co. v. Buehler, 432 F.Supp.2d 1024, 1027 (C.D.Cal. 2000) (finding that reasoning from case addressing breach of fiduciary duty by a trustee was persuasive in case involving investment advisor because, “[l]ike a trustee, an investment advisor may be considered a fiduciary.”).

In sum, it is critical to identify the particular duty at issue in order to arrive at a proper damage calculation.  The broker’s duty of suitability is essentially a limited duty of care akin to the one at play in a negligence matter. The fiduciary duty, however, carries within it an entire penumbra of duties of which portfolio/investment suitability is just one.  If an alleged breach of fiduciary duty is limited to the adviser’s responsibility to recommend or make a suitable investment only, the damage calculations may indeed mirror the broker-dealer damage calculation.  An adviser’s breach of its fiduciary duty beyond the mere standard of investment care, however, requires the finder-of-fact to calculate “make-whole” damages.


[1]Miley v. Openheimer, 637 F.3d 318 (1981) is “the seminal case on damages in a suitability case[.]”
[2] A “surcharge” is relief in the form of monetary compensation for a loss resulting from a trustee’s breach of duty. The Supreme Court in CIGNA Corp. v. Amara, 131 S.Ct. 1866, 1880 (2011), stated that an ERISA fiduciary can be “surcharged” or ordered to pay money damages under the ERISA provision allowing a participant or beneficiary of the plan to obtain “other appropriate equitable relief.” In making this determination, the court stated that “[t]he surcharge remedy extended to a breach of trust committed by a fiduciary encompassing any violation of a duty imposed upon that fiduciary.” The court went on to conclude that “insofar as an award of make-whole relief is concerned, the fact that the defendant in this case, . . . , is analogous to a trustee makes a critical difference.”

Friday, March 28, 2014

Defamation v. Tortious Interference

Most of us have at least a “street-level” understanding of defamation. Individuals that hear or read damaging false statements about themselves or their business typically think: “I need to find a defamation lawyer.” They may be right. But if the defamatory statements at issue intersect with a commercial relationship or transaction, there is another avenue of relief and compensation that should be considered.
There are times when defamatory statements are intended to interfere with an existing business relationship. Take for example the case of investment adviser representative and broker Norm Meyer. He retained a fine lawyer, other than this firm, to go to war with his former broker-dealer1. Norm may have had some issues if he, or his lawyer, restricted their thinking to defamation. First and foremost, defamation claims typically have to be brought within one year. Other causes of action, such as breach of contract and tortious interference have much longer life-spans.
After a very long legal battle, Norm has his BrokerCheck (professional record) amended. The arbitration panel ordered a uniquely thorough Form U-5 expungement and a detailed amendment.
One more observation: defamatory statements, even in the commercial context, frequently get repeated in the media. One example is a business journal. Whether or not the media is liable for repeating the defamatory statements of another depends upon the facts and forum at play. A careful analysis of what was said and in what context is critical in determining whether or not the media should be added as defendants, if litigation is the path you must follow. 
Keep an eye on this blog to learn more about defamation, tortious interference, and reputation damage management and compensation.
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1 We represented Norm's colleague in the same matter.

Wednesday, March 19, 2014

Defamation Reputation Damage Management

In 1378, the Statute of Scandalum Magnatum granted judges and church officials in England a legal right to compensation if they had been insulted or defamed. The first Common Law defamation action on record was filed in England in 1507. Back then, however, the cause of action only applied to false utterances regarding criminality, incompetence, and disease. The law evolved dramatically in the United States. Indeed, Supreme Court Justice Stewart once wrote that the tort of defamation “reflects no more than our basic concept of the essential dignity and worth of every human being.1

Defamation law has been somewhat static since the seminal Supreme Court case of New York Times Co. v. Sullivan in 1964. But consider what has changed in the 50 years since that ruling. Let me cite just a few examples of developments that have completely transformed the impact of damages caused by defamatory conduct:
  1. An erosion of society's perception of what is a private matter;
  2. 24-hour news cycles;
  3. The relative decline of more thorough print media; and
  4. The internet (and the explosion of linked high-speed outlets for the dissemination of falsehoods.)

As the old saying goes, “A lie makes its way around the world before the truth has time to get its pants on.”

I will blog again shortly about the intersection of defamation and U-5 FINRA defamation claims. The lesson for now is as follows: brokers that have suffered from U-5 defamation need to do much more than simply file an arbitration claim. Reputation management is critical.
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1 If you want to dig deeper in to the legal history of defamation law, start with David Hudson's excellent piece by clicking here.

Wednesday, March 12, 2014

Missouri Supreme Court Rejects Trade Secret Claim Over Client List

Troy Kennedy (Kennedy”) left his position as director and executive officer of a trust and investment company when that company was bought by Central Trust & Investment Company (“CTI”). Kennedy left to found a competing firm. Both companies provided financial advice and investment management services. Within six months, Kennedy had successfully solicited 85 former clients.

Before the sale and departure in question, Kennedy had placed a detailed list of 200 clients in a safe deposit box upon the advice of legal counsel. Kennedy did not register his new company, ITI, with the SEC as an investment adviser. Instead, Kennedy affiliated himself as an investment adviser representative of an RIA called SignalPoint Asset Management, LLC (“SignalPoint”), the defendant in this case. The agreement between Kennedy and SignalPoint allowed Kennedy to offer investment services through SignalPoint in exchange for various fees on an independent contractor basis.

CTI filed suit against Kennedy and his new company, ITI. At the time it filed suit, it didn't even know about the client list in the safe deposit box. The suit included causes of action for conspiracy, misappropriation of trade secrets (MUTSA) and tortious interference with business relations. CTI then added SignalPoint as a third defendant. All three defendants filed motions for summary judgment. The trial court granted SignalPoint's only. The Supreme Court ordered the matter transferred to it from the Court of Appeals. The Supreme Court's analysis of the three different claims begins on page 7 of the 2014 Opinion [Click HERE]. The Opinion is a must read for attorneys representing agents or representatives that are about to “change ships” or broker-dealers or RIAs that are taking on a competitor's producer.

The Supreme Court sustained the dismissal of the statutory trade secret claim because CTI could not establish that SignalPoint had access to the client list. In doing so, it side-stepped the issue of whether the client list qualified as a trade secret. Ironically, the most valuable portion of the opinion for practitioners might be the two extensive footnotes (8 and 9) about client lists that prove that lawyers and judges can render obscure what should be obvious. Regardless, the Supreme Court concluded that because there was no access, there was no misappropriation, so there was no MUTSA violation.

The first 10 pages of the opinion fail to pin the law to the reality of the situation—that Kennedy had access to the list and was using it to benefit himself and SignalPoint. Ironically, the plaintiff's attorney couldn't pin that tail on the donkey either—he or she somehow failed to plead any theory of vicarious liability. The theory of respondent superior was not available either—Kennedy's IAR Agreement clearly established him as a non-employee. CTI needed but failed to plead that Kennedy was an agent over whom SignalPoint had a sufficient degree of control.

The Court proceeded to set forth the elements of a claim for tortious interference:

“To prove a claim for tortious interference with a contract or a business expectancy, the plaintiff must prove the following five elements: “(1) a contract or a valid business expectancy; (2) defendant's knowledge of the contract or relationship; (3) intentional interference by the defendant inducing or causing a breach of the contract or relationship; (4) absence of justification; and (5) damages resulting from defendant's conduct.”

The Court concluded that the fourth element requires a showing of “improper means” and the plaintiff could not establish any because there was no misappropriation of a trade secret. The civil conspiracy claim died from the same wound. Food for thought.


The Cosgrove Law Group represents individual agents and reps both before and after they make a move to a new B/D or RIA. Retaining counsel before the litigation starts just might help you prevail and prosper.