The Use of Social Media for Investment Advice. The Struggle Between Employee Privacy Laws and Investor Protection

The landscape of communication has changed drastically in the past decade.  Information has the capability of widespread reach through the use of various sources.  In particular, social media has become an important channel of communication.  As such, the SEC has recently issued new guidance that allows financial firms to disseminate market related news via social media so long as firms alert investors which social media platforms will be used to deliver such information.  Financial firms’ use of social media must be in compliance with Regulation FD which “requires companies to distribute material information in a manner reasonably designed to get that information out to the general public broadly and non-exclusively…to ensure that all investors have the ability to gain access to material information at the same time.” 

Another emerging issue in the height of social media is employee privacy.  Recently, various states have made efforts to curtail employers’ attempts to monitor employees’ personal Facebook and Twitter accounts.  California, Illinois, Maryland, and Michigan adopted social media privacy laws last year while a similar law in Utah takes effect in May.  Variations of social media privacy laws have been introduced in 35 states since the beginning of 2013.

Securities regulators, however, have requested states to carve out exceptions in such state laws so that certain financial firms can maintain a close watch of the social media accounts of its employees in order to monitor whether personal accounts are being used to give investment advice. Regulators such as FINRA worry that social media networks can create new channels for Ponzi schemes and other frauds and ultimately put investors at risk. According to a survey conducted by American Century Investments, approximately one third of financial advisers use some form of social media several times a week to interact with investors.

Before California’s employee-privacy laws took effect at the start of the year, FINRA and other related groups requested that either the law be vetoed or an exception carved out for financial firms.  California rejected this request.  California’s law prohibits employers from requiring or requesting employees’ to: (1) disclose his or her username or password for the purpose of accessing social media; (2) access personal social media in the presence of the employer; or (3) divulge any personal social media.  Employees cannot be disciplined, terminated, or retaliated against for non-compliance if an employer makes such a request.     

Some state laws provide a narrow exception for employers to conduct legitimate checks of an employee’s personal social media accounts during a formal investigation of an employee’s alleged misconduct.  Nevertheless, securities regulators and financial firms would rather get in front of the issue and monitor employee’s conduct before it rises to the level of a formal investigation or before the potential harm to investors has been done. 

Securities regulators believe current employee-privacy laws are at odds with existing rules that require financial firms to monitor any investment advice that is posted or tweeted by employees.  Financial firms have found themselves between a rock and a hard place when it comes to the issue of employee privacy and compliance with regulations and will likely be faced with deciding whether to violate state law or SEC and FINRA regulations.    

Courts have yet to decide whether FINRA rules will supersede state law on this matter.

For further guidance on how financial firms can work within the bounds of state laws while maintaining its obligations to FINRA contact the experienced attorneys at Cosgrove Law Group, LLC. 

Second Circuit Finds That SEC is Immune from Lawsuit by Bernie Madoff Victims

In Molchatsky, et al. v. United States, 11-2510-cv(L), the Plaintiffs sought to hold the United States liable for SEC employees’ failure to detect Bernard Madoff’s Ponzi scheme and for the financial losses that Plaintiffs claim they suffered as a result. The Plaintiffs’ principal allegation was that the SEC negligently failed to uncover Madoff’s fraud despite receiving numerous complaints over a sixteen-year period. Plaintiffs claim that the SEC’s clear negligence exposes the agency to liability under the Federal Tort Claims Act (“FTCA”).

The FTCA is an exception to the rule that the United States is typically immune from suit. The district court determined that the Discretionary Function Exception (“DFE”), an exception to the exception to the rule of United States immunity, barred Plaintiffs’ claims. The DFE suspends the FTCA from applying to:

[a]ny claim based upon an act or omission of an employee of the Government, exercising due care, in the execution of a statute or regulation, whether or not such statute or regulation be valid, or based upon the exercise or performance or the failure to exercise or perform a discretionary function or duty on the part of a federal agency or an employee of the Government, whether or not the discretion involved be abused.

28 U.S.C. § 2680(a).

The Second Circuit Court of Appeals agreed with the district court. The court of appeals stated that the DFE is not about fairness, it “is about power,” National Union Fire Insurance v. United States, 115 F.3d 20 1415, 1422 (9th Cir. 1997); the sovereign “reserve[s] to itself the right to act without liability for misjudgment and carelessness in the formulation of policy,” id. “[T]he DFE bars suit only if two conditions are met: (1) the acts alleged to be negligent must be discretionary, in that they involve an ‘element of judgment or choice’ and are not compelled by statute or regulation and (2) the judgment or choice in question must be grounded in ‘considerations of public policy’ or susceptible to policy analysis.” Coulthurst v. United States, 214 F.3d 106, 109 (2d Cir. 2000) (quoting United States v. Gaubert, 499 U.S. 315, 322-23 (1991)) The court of appeals noted that Plaintiffs bear the initial burden to state a claim that is not barred by the DFE. See Gaubert, 499 U.S. at 324-25.

The court of appeals concluded that in the case before it, the Plaintiffs failed to make the necessary showing. The conduct Plaintiffs sought to challenge was “too intertwined with purely discretionary decisions” made by SEC personnel. Gray v. Bell, 712 F.2d 490, 515 (D.C. Cir. 1983); see generally id. at 515-16.

While the court expressed sympathy for Plaintiffs’ predicament (and at the same time expressing antipathy for the SEC’s conduct), it found that Congress’s intent to shield regulatory agencies’ discretionary use of specific investigative powers via the DFE was fatal to Plaintiffs’ claims. See Berkovitz by Berkovitz v. United States, 486 U.S. 531, 538 & 538 n.4 (1988) (quoting H.R.Rep. No. 1287, 79th Cong., 1st Sess., 616 (1945)). The court found that the first prong of the DFE was satisfied because the SEC retains complete discretion over when, whether and to what extent to investigate and bring an action against an individual or entity. See 15 U.S.C. § 78u(a)(1); 17 C.F.R. § 202.5(a)-(b). It also found that the second prong of the DFE was satisfied by virtue of the SEC’s choices regarding allocation of agency time and resources being sufficiently grounded in economic, social and policy considerations. See Bd. of Trade of City of Chicago v. SEC, 2 883 F.2d 525, 531 (7th Cir. 1989); cf. Coulthurst, 214 F.3d at 108-11.

The court concluded that the SEC’s actions, along with its “regrettable inaction,” were shielded by the Discretionary Function Exception, and affirmed the district court’s dismissal of Plaintiffs’ claims for lack of subject matter jurisdiction.

Hedge Fund Hoax

Though created to “hedge against risk” and maximize gains through aggressive and advanced investment strategies, one recent hedge fund lawsuit against a prominent investment company may undermine confidence in this fundamental function of hedge funds. In September of last year, the Securities and Exchange Commission brought formal charges against Walter V. Gerasimowicz, Meditron Management Group, LLC (MMG) and Meditron Asset Management, LLC (MAM), for misusing client hedge fund assets from September 2009 through September 2011. 

Gerasimowicz, a well established and highly successful New York City investment strategist, is the owner of both MMG and MAM. The SEC’s charges against the three respondents allege all parties played a role in siphoning millions of dollars from their hedge fund client, Meditron Fundamental Value/Growth Fund, LLC. In its Order, the SEC alleges the money was used to keep Gerasimowicz’s failing contracting company, SMC Electrical Contracting, afloat as it dealt with bankruptcy proceedings. Nearly 80% of Meditron Fund’s assets were transferred to SMC over a two year period, in disregard of their client’s investment interests. Gerasimowicz and MAM maintained their claims that MAM held a diversified portfolio and allegedly withheld information regarding their investment deviations, even though these deviations contradicted their stated investment strategies. 

 Over the two year period of the respondents’ alleged shenanigans, Gerasimowicz sent Meditron Fund investors quarterly statements that neglected to show the company’s “investment” in SMC. Furthermore, the Investment Advisers Act of 1940 requires financial statements relating to client funds to be prepared and audited in accord with GAAP, by a PCAOB approved public accountant. Financial statements were prepared by Gerasimowicz, not a public accountant, before being dispersed to clients and audited statements were subject to lengthy, year long delays before completion.

Additionally, the respondents allegedly recruited new MAM and MMG investors and misled current clients by misrepresenting MAM’s assets at $1.1 billion. Though the respondents claimed they were working to minimize risk, their payments to SMC did anything but. The SEC found that third party investors with full knowledge of SMC’s situation were hesitant to invest in the company and could not be maintained unless Gerasimowicz himself personally guaranteed repayment of their financing. The SEC’s Order also alleges that the respondents neglected to perform any valuation analysis of their “investment” of Meditron Fund’s assets in SMC. 

Gerasimowicz, Meditron Management Group, and Meditron Asset Management are alleged to have violated various sections of the Securities Act of 1933, the Securities and Exchange Act of 1934, and the Investment Advisers Act of 1940. The judge on this matter is set to issue an opinion no later than 300 days from the Order’s date of service.

Arbitration Agreements Mandating Arbitration Before the NASD May Be Unenforceable

Keller v. ING Financial Partners, Inc., No. 2011-193026 (S.C. App. Jan. 9, 2013) is an interesting unpublished opinion out of the state of South Carolina whose reasoning, if followed in other jurisdictions, could have a rather profound effect on client/broker-dealer arbitration agreements entered into prior to July 2007. In that case, the circuit court's denied ING Financial Partners’ motion to compel arbitration. The circuit court found the arbitration agreement between the parties designated the National Association of Securities Dealers (NASD) as an exclusive arbitral forum, the NASD was unavailable to arbitrate because it no longer existed, and the court could not substitute the Financial Industry Regulatory Authority (FINRA) for NASD.

The court noted that the Federal Arbitration Act (FAA) does not confer an absolute right to compel arbitration, but only a right to obtain an order directing that "arbitration proceed in the manner provided for in [the parties'] agreement." Volt Info. Scis., Inc. v. Bd. of Trs. of Leland Stanford Junior Univ., 489 U.S. 468, 469 (1989) (emphasis added). The agreement at issue stated "any dispute between you and me arising out of this agreement shall be submitted to arbitration conducted under the then applicable provisions of the code of arbitration procedure of NASD." The NASD's rules indicated that conducting arbitration "under the then applicable provisions of the code of arbitration procedure of NASD" mandated arbitration before the NASD itself. But the NASD was no longer available to arbitrate because in July 2007 FINRA was created through the consolidation of the NASD and the member regulation, enforcement and arbitration functions of the New York Stock Exchange (NYSE).

The court of appeals found that it could not rewrite the parties' agreement to substitute FINRA for NASD. The court noted that neither Iowa state (the law that applied) nor the Eighth Circuit Court of Appeals had decided whether a court may substitute an arbitral forum when a designated forum had become unavailable to arbitrate. Among federal circuit courts, the court noted that a split existed on the issue. In the absence of any controlling law, the court opted to follow Grant v. Magnolia Manor-Greenwood, Inc., 383 S.C. 125, 678 S.E.2d 435 (2009). There, the South Carolina Supreme Court saw "great merit in the Second Circuit's view that Section 5 [of the FAA] does not apply in cases where a specifically designated arbitrator becomes unavailable" to arbitrate. Id. at 131, 678 S.E.2d at 438 (approving of In re Salomon Inc., 68 F.3d 554 (2d Cir. 1995)).

In Salomon, the Second Circuit held that Section 5 of the FAA permits substitution only "when there is 'a lapse in time in the naming of the' arbitrator or in the filling of a vacancy on a panel of arbitrators, or some other mechanical breakdown in the arbitrator selection process." See Salomon, 68 F.3d at 560 (emphasis added). The court noted that the case before it did not present a breakdown in the process of selecting an arbitrator because the arbitral forum simply did not exist. Regardless of any similarities between NASD's and FINRA's procedural rules, the court of appeals found that it could not impose upon the parties the power of an arbitral forum that they did not agree to submit to. As a result, the court of appeals found that the trial court properly denied Appellants' motion to compel arbitration.

FINRA Hearing Panel Concluded that FINRA Arbitration Rule was Preempted by Federal Arbitration Act

FINRA Department of Enforcement recently brought an enforcement action against Charles Schwab (“Schwab”) after the firm amended its customer account agreement to include provisions that would require customers to waive their rights to bring or participate in judicial class actions against the firm. The amended agreement also required customers to agree that an arbitrator would not have authority to consolidate more than one party’s claims. 

In the first two causes of action, FINRA alleged that Schwab’s pre-dispute arbitration agreements which force customers to waive rights to participate in judicial class claims violate FINRA Rules 2268(d)(1) and (d)(3) which state, “(d) No pre-dispute arbitration agreement shall include any condition that: (1) limits or contradicts the rules of any self-regulatory organization; and (3) limits the ability of a party to file any claim in court permitted to be filed in court under the rules of the forums in which a claim may be filed under the agreement.” FINRA argued that Schwab’s agreement interfered with FINRA Arbitration Rule 12204(d) which preserves a customer’s option to file claims as a part of a judicial class action. Since FINRA has separate rules that prohibit class actions in arbitrations, customers would be barred from bringing a class action against Schwab in any forum.

FINRA alleged in its third cause of action that requiring customers to agree that arbitrators lack authority to consolidate parties’ claims violates FINRA Rule 2268(d)(1). FINRA contended that such a provision limits or contradicts FINRA Arbitration Rule 12312 which covers specific circumstances in which an arbitrator may consolidate claims. 

The parties had differing opinions on how the Federal Arbitration Act (“FAA”) played a role in the matter. Enforcement argued that the FAA was irrelevant and inapplicable because the only determination that need be made when imposing sanctions is whether Schwab violated FINRA Rules. Schwab’s position was that even if the waiver violated FINRA Rules, the FAA preempts FINRA rules and bars their enforcement.

In the Hearing Panel’s order, the first two claims were dismissed. While the Panel found that Schwab’s amendments to the customer agreements did violate FINRA Rules 2268(d)(1) and (d)(3), the rules cannot be enforced in light of the FAA, as construed by the United States Supreme Court in AT&T Mobility, LLC v. Concepcion. The Panel stated that the Supreme Court disfavors rules that override agreements to arbitrate and that such hostility to arbitration is unenforceable. The Concepcion case specifically established that class actions are no exception to the general rule and that a party to an arbitration agreement cannot undermine the agreement by participating in class actions.

In regard to Enforcement’s third cause of action, the Panel found that the language which limits the         power of arbitrators to consolidates cases violates FINRA Rule 2268(d)(1) in that the agreement:

(i) “undermines the fundamental operation of rule 12312 and, in fact, the overall operation of FINRA Arbitration Rules generally, by depriving FINRA of its authority to grant and circumscribe the power of arbitrators in FINRA’s forum; and (ii) the consolidation language undermines the specific authority given to the arbitrators to join individual claims in specified circumstances.

The Panel also found that the FAA did not bar enforcement of the rules in this instance because the FAA does not govern how arbitration forums operate. 

Therefore, Schwab was ordered to take corrective action by removing the language regarding an arbitrator’s power to consolidate claims and notify customers that such language is not effective. Schwab was also ordered to pay a fine of $500,000. 

FINRA still has the option of appealing to the National Adjudicatory Council within 45 days of the hearing panel’s decision. Thus, as it stands, while pre-dispute arbitration agreements that require a customer’s waiver of class claims may be volatile of FINRA Rules, such rules cannot be enforced to allow sanctions against FINRA member firms. Essentially, firms could effectively avoid being subject to class claims in any forum. This may prompt FINRA to reevaluate class arbitration rules.

FINRA’s 2012 Year in Review

FINRA just released its 2012 Year in Review Report.  In its opening remarks, FINRA’s Chairman and CEO, Richard Ketchum, stated, “FINRA fulfilled its role as the first line of defense for investors through a comprehensive and aggressive enforcement program, supported by a realigned and more risk-based examination program and the provision, for the first time, of cross-market surveillance programs that more effectively detected electronic manipulative trading. Protecting investors and helping to ensure the integrity of the nation’s financial markets is at the heart of what we do every day.

Regulatory

FINRA noted that one of its regulatory highlights was the success of its referral program in which the Office of Fraud Detection and Market Intelligence (“OFDMI”) shares regulatory intelligence with the SEC and other law enforcement agencies. Its intelligence stems from OFDMI’s fraud and insider trading surveillance of nearly all U.S. equities markets.  In 2012, FINRA referred a total of 692 matters to the SEC and other law enforcement agencies, of which 347 involved insider trading and 260 involved fraud. 

Disciplinary and Enforcement

In addition to its referrals program, FINRA brought 1,541 disciplinary actions against registered firms and individuals, levied fines in excess of $68 million, and ordered $34 million in restitution to harmed investors.  FINRA expelled a total of 30 firms from the securities industry, barred 294 individuals, and suspended 549 brokers from associating with FINRA-regulated firms. 

Some of the complex products involved in 2012 disciplinary and enforcement actions were non-traded REITs, exchange-traded funds (ETFs), and structured products.  Other enforcement actions involved research analyst conflicts, mispricing, and improper reimbursement fees to lobbying groups. 

Another critical aspect of FINRA is its examinations of member firms and associated persons.  In 2012, FINRA initiated 1,846 routine examinations, over 800 branch office examinations, and 5,100 examinations resulting from customer complaints, terminations for cause, and other regulatory tips.  FINRA’s exam procedures were made more efficient due to advances in technology which has provided FINRA with a modernized framework that allows it to identify and prioritize areas of risk exposure at firms. 

Investor Protection

Of grave importance to investors was FINRA’s new suitability rule that was implemented July 9, 2012.  The rule requires broker-dealers and/or their associated persons “to have a ‘reasonable basis’ to believe a recommended investment is suitable for the customer, based on information obtained through ‘reasonable diligence’ to understand a customer’s investment profile.”  For more investor information on FINRA’s suitability rule, click here.

FINRA also proposed an investor-protection initiative in 2012 that attempts to address conflicts of interest relating to recruitment compensation practices of member firms offering incentives to recruit registered representatives.  Currently these compensation arrangements are not disclosed to the representative’s customers when they are asked to transfer their accounts to a representative’s new firm.  The rule would require the member firm to provide certain disclosures before a customer makes the final determination to transfer an account to the new firm.  The view the text of the proposed rule, click here.

In September 2012, FINRA obtained approval to file proposed rules that would require firms to include a reference and a link to BrokerCheck on their websites to make it easier for investors to obtain information on firms and brokers. FINRA also increased the user friendliness of BrokerCheck by including a zip code search and a combined search function that provides for easier access to the SEC’s Investment Adviser Public Disclosure (IAPD) database. 

In November 2012, FINRA Dispute Resolution released data which reflects the outcomes of cases heard under its all-public panel program that was implemented in February 2011 which allows investors the option of a panel comprised of all public arbitrators versus a panel made up of one arbitrator with securities industry experience (nonpublic arbitrator) and two public arbitrators. The all-public panel option represents an investor-friendly change to the program, designed to ensure a fair playing field for all parties. To date, the data indicates that in cases decided by three public arbitrators, customers were awarded damages 51 percent of the time, whereas in cases decided by a panel including one nonpublic arbitrator and two public arbitrators, investors were awarded damages 32 percent of the time.  For the full data report, click here.

Notably, FINRA and the FINRA Investor Education Foundation have continued to enhance its outreach strategies and investor education by distributing educational brochures, holding live events, and creating an Outsmarting Investment Fraud curriculum.  The Foundation also put  more focus into providing services for military families through their military financial readiness project. 

Crowdfunding

A hot new topic in 2012 was “crowdfunding” since new provisions relating to crowdfunding were introduced in the April, 2012 JOBS Act.  To ensure that the capital-raising objectives of the JOBS Act can be advanced while simultaneously protecting investors, FINRA has requested and solicited comments on specific rules it should adopt for registered funding portals that become FINRA members.  In addition, FINRA has also asked for comments on the application of its existing rules to broker-dealers engaging in crowdfunding activities. 

If you’re a FINRA member firm, associated person, or an investor involved in a potential FINRA-related claim, contact the experienced attorneys at Cosgrove Law Group, LLC for assistance. 

Former Morgan Stanley Branch Manager Awarded $1 Million in Compensatory Damages in a FINRA New Years Day Award.

In 2011, Claimant Gregory Carl Torretta (“Torretta”) filed a claim with FINRA against Respondent Morgan Stanley Smith Barney (“Morgan Stanley”) for violations of FINRA rules, breach of employment contract, and wrongful termination.

Torretta was a former branch manager at Morgan Stanley at a two-branch complex in Garden City, New York. His termination allegedly stemmed from his oversight of another manager who was underperforming in his duties. The unidentified manager complained to Torretta about the oversight process in an email that was copied to Torretta’s boss. The email also implied that Torretta had discussions about leaving Morgan Stanley and suggested that Torretta encouraged the manager to follow him.

Despite denying the allegations of having those discussions with the manager, Torretta was given the choice to voluntarily resign or be terminated. Torretta chose to voluntarily resign. The key issue in the case was Morgan Stanley’s own procedures for handling such matters which Torretta alleged were not followed.

In Torretta’s statement of claim, he requested compensatory damages in the amount of $4.5 million. At the close of the hearing, Torretta requested compensatory damages ranging from $8 million to $9 million.

The hearing took place in New York City in front of Chairperson Marguerite Filson, Public Arbitrator Paul Blederman, and Non-public Arbitrator Joel Morton Newman. On January 1, 2013, the panel awarded Torretta $1 million in compensatory damages. In customary fashion, the panel did not explain the award.

If you believe you have been wrongfully terminated from a FINRA Member Firm, please contact the experienced attorneys at Cosgrove Law Group, LLC.

For a copy of the opinion, see FINRA Cause No. 11-01914.